**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

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

**Forthe fiscal year ended December 31, 2005**

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

**For the transition periodfrom                               to                            **

**Commission File Number 0-24752**

**Wave Systems Corp.**

(Exact name of registrantas specified in its charter)

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

 

**413-243-1600**

(Registrant’s telephonenumber, including area code)

Securities registered pursuant to Section 12(b) ofthe Act:

**None**

Securities registered pursuant to Section 12(g) ofthe Act:

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

(Title of Class)

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o  No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.   Yes x  No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this form 10-Kor any amendment to this Form 10-K.

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon- accelerated filer. See definition of “accelerated filer” and “largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large acceleratedfiler  o   Accelerated filer  x   Non-accelerated filer o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yeso  No x

As of December 31, 2005 there were 93,341,479 shares ofthe registrant’s Class A Common Stock and 175,725 shares of the Registrant’sClass B Common Stock outstanding. 

The aggregate market value of the shares of CommonStock of the registrant held by non-affiliates as of March 8, 2006, was$63,746,428 (for purposes of this calculation, the market value of a share ofClass B Common Stock was assumed to be the same as a share of Class ACommon Stock, into which it is convertible.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our definitiveProxy Statement for the 2006 Annual Meeting of Stockholders, to be filedpursuant to Regulation 14A on or before April 30, 2006, have been incorporatedby reference into Part III of this annual report.

 

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

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**Table Of Contents**
| PART I   |   | 2                                                                                                                               |
|---------------|--------|---------------------------------------------------------------------------------------------------------------------------------|
| Item 1.       |   | Business                                                                                                                        |   | 2 |
| Item 2.       |   | Properties                                                                                                                      |   | 20 |
| Item  3.      |   | Legal Proceedings                                                                                                               |   | 20 |
| Item 4.       |   | Submission of Matters to a Vote of Security Holders                                                                             |   | 21 |
| PART II  |   | 22                                                                                                                              |
| Item 5.       |   | Market for Registrant’s Common Equity and Related  Stockholder Matters                                                     |   | 22 |
| Item  6.      |   | Selected  Financial Data                                                                                                        |   | 24 |
| Item 7.  |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |   | 25 |
| Item 7A.      |   | Quantitative and Qualitative Disclosure about Market  Risk                                                                      |   | 44 |
| Item 8.       |   | Financial Statements and Supplementary Data                                                                                     |   | 44 |
| Item 9.       |   | Changes in and Disagreements with Accountant on  Accounting and Financial Disclosure              |   | 44 |
| Item 9A.      |   | Controls and Procedures                                                                                                         |   | 44 |
| Item  9B.     |   | Other  Information                                                                                                              |   | 46 |
| PART III |   | 47                                                                                                                              |
| Item 10.      |   | Directors and Executive Officers of the Registrant                                                                              |   | 47 |
| Item 11.      |   | Executive Compensation                                                                                                          |   | 47 |
| Item 12.      |   | Security Ownership of Certain Beneficial Owners and  Management                                                                 |   | 47 |
| Item 13.      |   | Certain Relationships and Related Transactions                                                                                  |   | 47 |
| Item 14.      |   | Principal Accountant’s Fees                                                                                                |   | 47 |
| PART IV  |   | 48                                                                                                                              |
| Item 15.      |   | Exhibits, Financial Statement Schedules, and Reports  on Form 8-K                                                          |   | 48 |

 

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**PART I**

**Item 1.**                        Business

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

The TCG is an industry standards body, comprised ofcomputer and device manufacturers, software vendors and others, whose purposeis to develop, define and promote open industry standard specifications forembedded hardware-enabled computing products, including security technologiesacross multiple platforms, peripherals and devices. The current TCGspecification recommends a hardware-based trusted computing platform, which isa platform that uses an implementation of the TPM specification into asemiconductor device, known as a Trusted Platform Module (“TPM”) that performsprotected activities, includingprotected storage, platform authentication, protected cryptographic processesand attestable state capabilities to provide the first level of trust for thecomputing platform (a “Trusted Platform”). The TPM is a hardware chipthat is separate from the platform’s main CPU(s) that enables secureprotection of files and other digital secrets, and performs critical securityfunctions, such as generating, storing and protecting “cryptographic keys,”which are secret codes used to decipher encrypted or coded data. While TPMsprovide the anchor for hardware security, known as the “root of trust”, trustis achieved by integrating the TPM within a carefully architected trustinfrastructure and supporting the TPM with essential operational and lifecycleservices, such as key management and credential authentication.

Prior to the formation of the TCG, Wave developed itspioneering EMBASSY (EMBedded Application Security SYstem)Trust System. The EMBASSY Trust System is a combination of client hardwareconsisting of the EMBASSY 2100 security chip (the “EMBASSY chip”); andsoftware  consisting of the TrustAssurance Network (“TAN”), a back-office infrastructure that manages itssecurity functions. Asthe market for TPM-enabled products has developed with computing devices beingshipped in volume by leaders in the PC industry, Wave has enabled thedevelopment work on the EMBASSY Trust System to support security hardware basedon the TCG specifications, by repurposing these product assets. Wave hassince developed a set of applications known as the EMBASSY Trust Suite, EMBASSYTrust Server products, middleware and software tools to work with various otherchip manufacturers’ TCG-enabled TPMs that are now available.   Wave’sproducts are unique in the fact that they support cross platforminteroperability for the currently available TPM chips from Winbond ElectronicsCorporation (“Winbond”), (formerly National Semiconductor Corporation (“NSC”),Atmel, Broadcom, Infineon, and STMicroelectronics and have been verified forusage on TPM platforms shipped by Intel, IBM, HP, Fujitsu, Gateway and Dell.

Wave’s operations to date have consisted primarily ofproduct development, performance under contract to develop products andpreliminary marketing to personal computer (“PC”) and Semi-conductor Chip (“Chip”)original equipment manufacturers (“OEMs”), resellers, and enterprises. Inaddition, Wave has signed distribution contracts for its products with a numberof OEMs that have resulted in a marked increase in revenues for the year ended December 31,2005 versus prior years.

Although Wave was successful in signing distributioncontracts with Intel, NSC (now Winbond) and ST Microelectronics, Wave’s total revenuehas not grown to a level that is significant in relation to our expenditures.As a result, we have******experienced a slow pattern of corporatedevelopment. As of December 31, 2005, we had negative working capital ofapproximately $1.1 million. Considering our current cash balance and Wave’sprojected operating cash requirements, we anticipate that we will need aminimum of approximately $12 million of additional cash to satisfy our currentforecasted cash flow 

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requirementsfor the year ending December 31, 2006. As discussed above, Wave has begunmarket introduction of its software products for Trusted Platforms and hassigned its first distribution contracts for these applications. However, due tothe early stage nature of its market category, Wave is unable to predict with ahigh enough level of certainty whether enough revenue will be generated incalendar 2006 to fund its cash flow requirements. Given the uncertainty withrespect to Wave’s revenue forecast for 2006, it is likely that Wave will berequired to raise additional capital through either equity or debt financing inorder to adequately fund its capital requirements for the year ending December 31,2006. Furthermore, in the event that we are successful in executing ourbusiness plan for 2006, we will likely still be in a cash shortfall positionand we will need to begin to generate sufficient sales to fund operations infuture years, or we will be required to raise additional capital to continuebeyond 2006. Due to our current cash position, our capital needs over the nextyear and beyond, the fact that we have not secured additional financing  at this time and uncertainty as to whether wewill achieve our sales forecast for our products and services, substantialdoubt exists with respect to our ability to continue as a going concern.

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

In April, 2003 the TCG was formed. The PromotingFounders were AMD, HP, IBM, Intel, and Microsoft, and Wave Systems was invitedto join the founding group as a Contributing Member. The TCG formally acceptedthe initial technical specifications developed by the Trusted ComputingPlatform Alliance (“TCPA”) for Trusted Platform Modules Version 1.1. TCGformally superseded the TCPA organization. The TCG has significantly expandedthe industry participation in security hardware standards with membership fromindustry leaders for important additional platforms including cell phones, PDAsand consumer electronics. During 2003, several manufacturers of semiconductorsfor the PC industry including National Semiconductor, Atmel and Infineon wereoffering products that have the capability to function as TPMs that meet theTCG TPM Version 1.1 standard for trusted computing.  In addition, PC platforms which included TPMswere announced and/or available from IBM, Intel, and HP. In 2004 the rate ofadoption of TPMs accelerated with additional platforms announced by the majorOEMs already shipping platforms and an additional OEM, Fujitsu, announcedproducts with TPM’s. In 2005 the rate of adoption of TPMs continued to growwith the availability of TPM-equipped PCs and servers from additional PC OEMsincluding Dell, Gateway  and Lenovo. Theoverall number of TPM-equipped PC models being offered from the OEMs shippingwith TPMs combined with the increased number of OEMs that have introducedTPM-equipped models has continued to accelerate the total rate of TPMs beingshipped by the PC industry.  In 2005, TheTCG released a new version of the TPM specification, Version 1.2 which includesa number of enhancements and extensions over the Version 1.1b. TPM Version 1.2is fully backwards compatible to Version 1.1b which provides a smoothertransition for deployment of the TPM technology and increases the TPMfunctionality. In addition, vendors such as Atmel announced TPM productstargeted to support embedded systems applications beyond the traditional PCmarket. There are also TCG Working Groups that are developing specifications toextend TCG technologies to other devices such as network products, servers,peripherals and mobile devices.

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

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**Products and Services**

***Client-side Applications***

*The EMBASSY TrustSuite*

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

The ESC enables the user to set up and configure theTPM platform. In addition to the basic function of making the TPM operational,ESC is designed to enable the user to manage extended TPM-based securitysettings and policies, including strong authentication, Windows logonpreferences to add biometrics and streamlined password policy management. Wavealso announced that it would develop the Trusted Drive Manager functions forESC to support the newly announced Seagate Full Disc Encryption drives.

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

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

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

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

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

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

Wave plans to continue todevelop and enhance the current products being developed within this productgroup and will develop new applications and services as the trusted computingmarket continues to evolve. Current planned development costs for this productgroup are expected to be approximately $2.7 million for the year ending December 31,2006.

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***Middleware and Tools***

*TCG-Enabled Toolkit*

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

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

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

Current planneddevelopment costs for this product group are expected to be approximately $2.4million for the year ending December 31, 2006.

***EMBASSY Trust Server Applications***

*EMBASSY KeyManagement Server (EKMS)*

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

*EMBASSY AuthenticationServer (EAS)*

EAS provides centralized management, provisioning andenforcement of multifactor domain access policies. With EAS, authenticationpolicies can be based on TPM credentials, Smart Card credentials, userpasswords and fingerprint templates. With EAS, authentication policies can beprovisioned and managed from the domain controller. EAS has an integratedbiometric template capability with support for a variety of 3rd-party vendors.

Current planneddevelopment costs for this product are expected to be approximately $1.1million for the year ending December 31, 2006.

***Digital Signature and Electronic Document Management***

On October 4, 2001, Wave acquired the digitalsignature and electronic document management technology, SmartSignature andSmartSAFE, from SignOnLine, Inc. (“SignOnLine”), a California-basedcompany. This group of products initially made up our eSign TransactionManagement Suite, also known as eTMS (“eTMS”), which consisted of four coreproducts: SmartIdentity, SmartSignature, SmartSAFE and SmartConnect. SmartSignatureVersion 3.0 is a digital signature application that connects signers andinstitutions—banks, insurance companies, enterprises, etc.—through a legallybinding digital signature. In Q4 of 2005, Wave launched SmartSignature Server,a server-side electronic signature application, which 

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enables individuals toelectronically sign and store virtually any format of document, while connectedto a server, as opposed to the signing taking place on the client PC**.**

To increase the security associated with identityprotection and digital signing credentials, Wave’s SmartSignature is currentlyenabled for the support of TPMs. SmartSAFE Version 3.0 is a web-baseddocument management application where signed documents are archived and tracked.SmartSAFE provides an easy to use environment where a client institution canview, manage, store and transfer sensitive signed and unsigned documents. SmartSAFEalso supports archival and management of unsigned documents in virtually anyformat. These products allow a document to be executed, verified, accepted andfiled in minutes at a lower cost compared to traditional paper-baseddocumentation methods. SmartSignature Version 3.0 and SmartSAFE Version 3.0have been completed and Wave commercially released these products in the firstquarter of 2003. SmartIdentity, an optional service to verify a signer’sidentity through strong authentication methods, including issuing encrypteddigital certificates based on public key infrastructure technology, wascompleted and released in January of 2003. Wave will continue to allocateresources toward marketing and sales to promote these products.

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

Current planneddevelopment costs for this product are expected to be approximately $449,000for the year ending December 31, 2006.

***Broadband Media Distribution Services***

Wave offers broadband content distribution productsand services through Wavexpress, a joint venture between Wave and SarnoffCorporation. The joint venture was established on October 15, 1999. Underthe joint venture agreement, Sarnoff and its affiliates received a 40% equitystake in Wavexpress. Wave received a 53% equity interest and its affiliates,who purchased founders stock in April 1999 for a nominal amount, owned theremaining 7% of the outstanding capital stock. The affiliates of Wave includePeter Sprague, former Chairman of Wave, Steven Sprague, Chief Executive Officerof Wave, certain members of the Board of Directors of Wave and certain Waveemployees.

Wavexpress has developed a vertically integrated suiteof products designed to enable the optimum broadband distribution of digitalprogramming. The current product offering combines industry standardsyndication protocols with proprietary back-end software to create anend-to-end content syndication and monetization platform. This system isoffered to content providers looking to deliver high-quality broadband mediaservices using either Wavexpress’ distribution facility or on their own,through Really Simple Syndication (“RSS”). RSS is the standard format for blogsand podcasts and is being increasingly used for open video distribution on theInternet. Content providers connect through the Wavexpress client and backendsoftware to generate advertising revenue or subscription fees for premiumservices. Wavexpress’ business model intends to derive revenue either fromdirect fees charged to content providers for the use of Wavexpress software andfacilities, or from a share of advertising proceeds collected. 

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Wavexpress proprietaryclient software is integrated and promoted through Microsoft’s Media CenterEdition operating system, as well as with Microsoft’s Internet Explorer webbrowser.

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

Planned future development expenditures are expectedto approximate $1.1 million for the year ending December 31, 2006. As of December 31,2005, Wave owned 69% of Wavexpress and Sarnoff owned 25.6%.

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

Wave, as well asWavexpress, is a development stage company and has realized minimal operatingrevenues since our inception. For the years ended December 31, 2005, 2004,and 2003 Wave incurred losses to common shareholders of approximately$17,562,000, $14,498,000 and $25,292,000, respectively. At December 31,2005 we had an accumulated deficit of approximately $284,747,000. There can beno assurance that we will ever be successful in achieving commercial acceptanceof our products and services.

**Markets and Business Strategy**

*Our Market*

Software has traditionally secured criticalinformation on networks and PCs and allowed for user access to variousapplications. However, virus attacks and breaches of security have proven thatsoftware, on its own, is not capable of completely securing a network orplatform. Because ofthese persistent security concerns, there is now a recognized need in thecomputer industry for the development and deployment of a more robust andreliable security infrastructure including new security hardware in devicesto guard against these persistent security risks. The TCG was formed todevelop, define and promote open industry standard specifications for embeddedhardware-enabled trusted computing and security technologies, including securehardware and software interfaces across multiple platforms, peripherals anddevices. The underlying premise of the creation of a Trusted Platform thatmeets the TCG specification is that only when a platform is secured byhardware, in effect creating a root of trust and an authenticatable securityenvironment within the computer itself, will the information stored on theplatform be adequately secure. Wave is seeking to become a software, applicationand servicesleader in hardware-based digital security ande-commerce products markets. Because Wave has been a pioneer in developinghardware-based computer security systems, it is distinctively positioned totake advantage of its unique knowledge, significant technology assets andtrusted computing intellectual properties.

Because hardware-basedtrusted computing involves a new approach to conducting business and exchanginginformation using computer systems, it will require that traditional software-basedsecurity be augmented with next generation hardware-based security and anenhanced support infrastructure. Intensive marketing and sales efforts havebeen and will continue to be necessary, in order to generate demand forproducts using Wave’s technology, and to ensure that Wave’s solution isaccepted in this emerging market. Our objective is to make our EMBASSY brandedproducts and services the preferred applications and infrastructure for TrustedPlatforms. Key components in achieving this goal include:

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***Capitalizing on Information Security Industry Trends***

For 2005 and 2006 security remains one of the topindustry priorities across multiple segments of the user and product valuechains. This top priority is supported by increased spending budgets and high productadoption rates of new security offerings. Virtually all segments within thesecurity markets are seeing increased focus.

Wave believes that a key differentiator of its EMBASSYTrust Suite is that it is interoperable across all of the currently availableTPM-enabled Windows platforms and provides for ease of use. Key industryinitiatives and security specifications that will require the addition oftrusted hardware are moving forward in a number of platforms includingMicrosoft’s Next Generation Secure Computing Base (“NGSCB”) now known asWindows Vista operating system, Intel’s LaGrande secure computing program, andAMD’s Secure Execution Mode (“SEM”). Similar programs are under considerationin network devices, and mobile devices such as PDAs and cell phones andconsumer electronics devices.

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

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

·       Usermanaged security features

·       Majorprivacy concerns

·       Rapiddevelopment of new e-commerce business and distribution models

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

·       Convergenceof consumer electronics and PC’s

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

·       Increasedfocus on security and privacy by government entities

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

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

***Pursue Strategic Marketing and Distribution Alliances***

We intend to expand Wave’sstrategic alliances with key partners that could distribute our products inenterprise, government and eventually consumer markets, and to build upon ouralliances with such industry leaders as Intel, Dell, HP, IBM, Lenovo, Gatewayand others in the PC industry. In addition, we are engaged in strategicactivities with semi-conductor manufacturers Winbond (formerly NSC), Atmel,STMicroelectronics and Infineon Technologies to support and/ordeploy EMBASSY applications with their TPMs designed to the TCG specifications.TCG has expanded its scope to includenetworking systems, trusted peripherals, data storage devices, mobile wirelessproducts and consumer electronics devices. Wave believes its trusted computingofferings can provide significant value in these new markets and platforms andthus, is working to establish relationships with key partners in each of thesemarkets. 

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For example, in 2004 Wave announced a relationshipwith ARM as part of the ARM Connected Community of technology partners as aimportant step in pursuing opportunities in these markets.

***Enhancing Our Current Product Offerings and Productsin Development***

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

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

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

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

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

These development effortswill likely be significant and Wave intends to expend a substantial portion ofits research and development resources towards these enhancements as well assignificant marketing and corporate development funds to introduce the productsand build market demand. As a result, our continued research and developmentefforts will require substantial capital resources, which will likelynecessitate the need for further funding so that Wave may ultimately be able tocapitalize on the emerging market opportunities for its products and services. Waveannounced major products in 2005, primarily for TPM applications, and isdeveloping significant new client and server based products and productenhancements which are planned to be introduced in 2006. For example: At theRSA Conference, 2006, on February 14th, 2006, Wave presented demonstrationswith both Juniper Networks and Nortel Networks, regarding the network securityand platform integrity capabilities of TPM-enabled systems.

***Marketing, Sales and Customers***

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

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OEMs, enterprise customersand systems integrators. Wave has also undertaken steps to develop andestablish a reseller channel for our products.

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

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

·       PCs—TCG’sstandards-based specifications for trusted hardware is leading the industrytoward increased deployment of TPM hardware by a growing number of PC OEMs. Thecurrent focus for both TCG and Wave is for business PC platforms, but will beextending into consumer PCs over time. Wave anticipates providing enablingtools to SIs, ISVs, andIHVs  in order to take advantage of thenew trusted computing features of these platforms.

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

·       Bankingand Finance**—**In addition to our Europeaninitiatives to be a leader in delivering solutions for European standards,which can provide strong authentication to services, we are aggressivelycultivating interest and support from financial institutions for utilizingTCG-compliant platforms.  In 2005, Waveupgraded its Liberty Alliance membership to Sponsor Level in order toparticipate in the new Strong Authentication Expert Group, which is beingdriven primarily by financial institutions which are looking for newalternatives for strong authentication for electronic transactions.

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

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

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

Wavexpress offers its technology and services on thebasis of a per-user fee and/or revenue share with the content owner, with aparticular focus on advertising supported entertainment services. In addition,Wavexpress publishes to the installed base of Microsoft Media Center PCs fivegeneral interest channels of entertainment programming offered under theTVTonic brand. Wavexpress’ client software and TVTonic channels arepre-installed with one high-end Microsoft Media Center PC OEM. Wavexpress islooking to expand to other manufacturers in 2006.

Wave’s sales for the yearended December 31, 2005 consisted primarily of licensing its softwareapplications, engineering and support services. Of the total revenue realizedfor the year ended December 31, 2005, 96% was derived from activitiesrelated to Wave’s computer security products and services and the remaining 4%was derived from Wavexpress’ broadband media distribution segment.  None of the customers from which Wave derivedrevenue in 2005 in excess of 10%, would have a material adverse effect on Wave’sbusiness if Wave were to lose such customers, because the level of sales duringthe year overall was not significant to Wave’s level of expenditures. However,Wave’s business plan on a forward-looking basis, will depend heavily on a smallnumber of OEM customers, partners and prospective 

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customers,the loss of, or lack of substantial future revenues from any of whom, may havea material adverse effect on our business plan going forward. These includeWinbond (formerly NSC), Intel, ST Microelectronics, Dell Computers, Inc.and others.

***Competition***

*Wave EMBASSYDigital Security Products*

We operate in the information security market, ahighly competitive and fragmented environment that is characterized by rapidlyevolving technology. Many of our competitors and potential competitors havesubstantially greater financial, technical and marketing resources than us. Also,many current and potential competitors have greater name recognition and moreextensive customer bases to leverage, allowing these competitors to gain marketshare or product acceptance to our detriment. In addition, the rate of marketacceptance of trusted computing solutions is still in the formative and earlystages. The markets for our products are developing and, while the TCGspecifications have provided the basis for the industry to move forward, thereremains significant standards work efforts in order for the eco-systemsupporting trusted computing to move forward.  Wave’s potential competitors include securitysolutions providers such as RSA Security, Inc., Symantec, ComputerAssociates, Verisign, Inc., Entrust, Inc., Utimaco, Safenet and majorsystems integrators such as IBM, HP and EDS. In addition, Wave competes withother client security applications companies that are developing trustedcomputer applications including Softex, Phoenix, Infineon and Microsoft. Thecompetitive factors defining these evolving markets include product features,compatibility, standards compliance, quality and reliability, ease of use,performance, customer service and support, distribution and price. Wavebelieves its products meet the requirements to be successful viable products inthese markets. The features of Wave’s products that should allow it to competefavorably through product differentiation include: cross-platform,interoperable solutions; easy-to-use features; and leading edge trustedclient/server infrastructure solutions. In addition, Wave continues to haveleading solutions with its digital signature products, especially when combinedwith trusted computing platforms and features.

One of the marketchallenges facing Wave is the establishment of a newly defined market categorywithin the overall information security market for trusted computing softwareand services that includes a more complex business model for adoption. Whilethe TCG specifications define a very complex and comprehensive cryptographicsystem that require significant skills and resources, the market for securitysolutions that are as complex as those developed by Wave is in a formativestage of development. As a result, commercialization of these technologies hasbeen slow to develop. It is also possible for other competitors to developsimilar offerings to compete with our products or new technologies may emergethat could replace existing technology that our products rely on, therebymaking our products non-competitive or obsolete. We can offer no assurancesthat Wave’s products will become industry standards or become widely acceptedby the marketplace.

*WavexpressBroadband Media Distribution*

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

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**International Market**

Most of our software products are controlled undervarious United States export control laws and regulations and may require exportlicenses for certain exports of the products and components outside of theUnited States and Canada. With respect to our EMBASSY Trust Suite softwareapplications, we have applied for and received export classifications thatallow us to export our products, without a license and with no restrictions, toany country throughout the world with the exception of Cuba, Iran, Iraq, Libya,North Korea, Sudan and Syria.

We believe the exportclassifications that we have received for our software products allow us tosell our products internationally in an effective, competitively advantageousmanner. Enhancements to existing products may, and new products, including theEMBASSY Trust Server applications, will be subject to reviews by the BXA todetermine what export classification they will receive. Some of our partnersdemand that our products be allowed to be exported without restrictions and/orreporting requirements. Current export regulations have, in part, allowed us toreceive the desired classification without undue cost or effort. However, theexport regulations may be modified at any time. Modifications to the exportregulations could prevent us from exporting our existing and future products inan unrestricted manner without a license, as we are currently allowed for theproducts that we’ve received classification, or make it more difficult to receive thedesired classification. If export regulations were to be modified insuch a way, we may be put at a competitive disadvantage with respect to sellingour products internationally.

**ProprietaryRights and Licenses and Intellectual Property**

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

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

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

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

**Research and Development**

Wave’s productsincorporate encryption/decryption, client and server software applications andother technologies in which we have made a substantial investment in researchand development. We will likely be required to continue to make substantialinvestments in the design of information security applications and services,including the EMBASSY Trust Suite, EMBASSY Server applications, eTMS products,and broadband media distribution products. For the years ended December 31,2005, 2004 and 2003 we spent 

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approximately$6.9 million, $6.9 million and $7.4 million, respectively, on research anddevelopment (“R&D”) activities. Planned development expenditures for theyear ended December 31, 2006 are expected to be approximately $7.8million.

**Employees**

As of December 31,2005, we employed eighty-six (86) full-time employees, thirty-eight (38)of whom were involved in sales, marketing and administration and forty-eight(48) of whom were involved in research and development (including fourteen (14)employed by Wavexpress, five (5) of whom were in sales, marketing andadministration and nine (9) of whom were involved in research anddevelopment). As of December 31, 2005, we retained the services of nine (9) full-timeconsultants, three (3) of whom were retained by Wavexpress. We believe ouremployee relations are satisfactory.

**Risk  Factors**

**We have a historyof net losses and expect net losses will continue. If we continue to operate ata loss, our business will not be financially viable.**

We have experienced significant losses and negativecash flow from operations since our inception. We have not realized a netoperating profit in any quarter since we began our operations, nor have wegenerated any significant operating revenue, as our products have not yetattained commercial acceptance. This is due primarily to the early stage natureof the digital security industry in which we operate. As of December 31,2005, we have a deficit accumulated during the development stage ofapproximately $284.7 million and negative working capital of approximately$1,112,000. Given the lack of significant sales of our products and services,there is little basis for evaluating the financial viability of our businessand our long-term prospects. You should consider our prospects in light of therisks, expenses and difficulties that companies in their early stage ofdevelopment encounter, particularly companies in new and rapidly evolvingmarkets, such as digital security and online commerce.

To achieve profitabilitywe must, among other things:

·       Convincechip, personal computer motherboard, personal computer and computer peripheralmanufacturers to license and distribute our products and services and/or makethem available to their customers through their sales channels;

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

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

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

·       Developrelationships with personal computer manufacturers and computer systemsintegrators to facilitate and to maximize acceptance of our products andservices; and

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

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

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

Since we began our operations, we have incurred netlosses and experienced significant negative cash flow from operations. This isdue to the early stage nature of market development for our products andservices and the digital security industry as a whole. Wave expects to continueto incur substantial additional expenses associated with continued research anddevelopment and business development activities that will be necessary tocommercialize our technology. This will likely result in significant losses forthe foreseeable future. Considering our current cash balance and Wave’sprojected operating cash requirements, we anticipate that our existing capitalresources will be adequate to satisfy our cash flow requirements into May 2006.In order to fund our business through May of 2006 and beyond, it will benecessary for us to generate substantial revenue, complete one or morecommercial or strategic transactions or raise additional capital. Wave isuncertain as to the availability of financing from other sources to fund anycash deficiencies. Even if we are successful in raising additional capital,uncertainty with respect to Wave’s viability will continue until we aresuccessful in achieving our objectives. Furthermore, although we may besuccessful at achieving our business objectives, a positive cash flow from operationsmay not ultimately be realized unless we are able to sell our products andservices at a profit. Given the early stage nature of the markets for ourproducts and services, considerable uncertainty exists as to whether or notWave’s business model is viable.

**We may be unable toraise the $12 million of additional cash flow, which is necessary to continueas a going concern for the next twelve months.**

Based upon our current expense forecast, we estimatethat our current available capital, including net proceeds of approximately$4,247,840 that we received from the sale of 8,348,598 shares of common stockon February 15, 2006, is sufficient to fund Wave into May of 2006. Inaddition to our efforts to begin to generate revenue sufficient to fund ouroperations, or complete one or more commercial or strategic transactions, Waveis evaluating additional financing options to generate additional capital inorder to continue as a going concern, to capitalize on business opportunitiesand market conditions and to insure the continued development of ourtechnology, products and services. We estimate, based upon our currentforecasts, that we will need to generate approximately $12,000,000, in additionto the $4,247,840 in proceeds referred to above, from a combination of revenuegrowth, commercial or strategic transactions and/or additional financings, tocontinue as a going concern for the twelve months ended December 31, 2005.We expect we will be required to generate a significant portion of this cashthrough additional financings in the form of sales of securities pursuant to ashelf registration statement filed with the SEC on December 16, 2006,which was declared effective on January 13, 2006. We do not know ifadditional financing will be available or that, if available, it will beavailable on favorable terms. If we issue additional shares of our stock, ourstockholders’ ownership will be diluted, or the shares issued may have rights,preferences or privileges senior to those of our common stock.  In addition, if we pursue debt financing wemay be required to pay interest costs.    The failure to generate sufficient cash flowto fund our forecasted expenditures would require us to reduce our cash burnrate which would in turn impede our ability to achieve our business objectives.Furthermore, if we are not successful in generating sufficient cash flow orobtaining additional funding, we will be unable to continue our operations,develop or enhance our products, take advantage of future opportunities,respond to competitive pressures and continue as a going concern.

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**Our market is in the early stage of development so weare unable to accurately ascertain the size and growth potential for revenue insuch a market.**

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

Wave’s business model relies on an assumed market oftens of millions of units shipping with built-in security hardware. Becausethis market remains in the early stage of development, there is significantuncertainty with respect to the validity of the future size of the market. Ifthe market for computer systems that utilize our products and services does notgrow to the extent necessary for us to realize our business plan, we may not besuccessful.

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

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

Wave’s offering represents a highly complexarchitecture designed to solve many of the security issues currently presentwith computer systems, such as identity theft, fraudulent transactions, virusattacks, unauthorized access to restricted networks and other security problemsthat users of computer systems generally encounter. We are uncertain as towhether the marketplace will accept our solution to these security problems. Wewill not be successful if the market does not accept the value proposition thatwe perceive to be present in our products and services.

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

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

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

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

Because the market in which we operate ischaracterized by rapidly changing technology, changes in customer requirements,frequent new products, service introductions and enhancements, and emergingindustry standards, our success will depend, among other things, upon ourability to improve our products, develop and introduce new products andservices that keep pace with technological developments, remain compatible withchanging computer system platforms, respond to evolving customer requirementsand 

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achieve market acceptanceon a timely and cost effective basis. If we do not identify, develop,manufacture, market and support new products and deploy new serviceseffectively and timely, our business will not grow, our financial results willsuffer, and we may not have the ability to remain in business.

**We encounter risksrelating to security, system disruptions and computer infrastructure that couldcompromise our digital content.**

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

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

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

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

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

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

Due in large part to Wave’s early stage and lower namerecognition, we depend upon strategic partners such as large, well establishedpersonal computer and semiconductor manufacturers and computer systems’integrators to adopt our products and services within the Trusted Computingmarketplace. These companies may choose not to use our products and coulddevelop or market products or technologies that compete directly with us. Wecannot predict whether these third parties will commit 

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the resources necessary toachieve broad-based commercial acceptance of our technology. Any delay in theuse of our technology by these partners could impede or prohibit the commercialacceptance of our products. Although we have established some bindingcommitments from some of our strategic partners, there can be no assurance thatwe will be able to enter into additional definitive agreements or that theterms of such agreements will be satisfactory. It will be necessary for Wave toexpand upon our current business relationships with our partners, or form newones, in order to sell more products and services for Wave to become a viable,self-sufficient enterprise.

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

We may experience delays in the development of our newproducts and services and the added features and functionality to our existingproducts and services that our customers and prospective customers are demanding.If we are unable to successfully develop products that contain the features andfunctionality being demanded by these customers and prospective customers in atimely manner, we may lose business to our competitors. In addition, despitetesting by us and potential customers, it is possible that our products maynevertheless contain defects. Development delays or defects could have amaterial adverse effect on our business if such defects and delays result inour inability to meet the market’s demand.

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

We believe that our future success depends upon thecontinued service of our key technical and management personnel and on ourability to attract and retain highly skilled technical, management, sales andmarketing personnel. Our industry is characterized by a high level of employeemobility and aggressive recruiting of skilled personnel. There can be no assurancethat our current employees will continue to work for us or that we will be ableto hire any additional personnel necessary for our growth. Our future successalso depends on our continuing ability to identify, hire, train and retainother highly qualified technical and managerial personnel. Competition forthese employees can be intense. We may not be able to attract, assimilate orretain qualified technical and managerial personnel in the future, and thefailure of us to do so would have a material adverse effect on our business.

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

Our success depends, in part, on our ability to enjoyor obtain protection for our products and technologies under United States andforeign patent laws, copyright laws and other intellectual property laws and topreserve our trade secrets. We cannot assure you that any patent owned orlicensed by us will provide us with adequate protection or will not bechallenged, invalidated, infringed or circumvented.

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

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**Regulation of international transactions may limit ourability to sell our products in foreign markets.**

Most of our software products are controlled undervarious United States export control laws and regulations and may requireexport licenses for certain exports of the products and components outside ofthe United States and Canada. With respect to our EMBASSY Trust Suite softwareapplications, we have applied for and received export classifications thatallow us to export our products, without a license and with no restrictions, toany country throughout the world with the exception of Cuba, Iran, Iraq, Libya,North Korea, Sudan and Syria.

We believe the export classifications that we havereceived for our software products allow us to sell our productsinternationally in an effective, competitively advantageous manner.Enhancements to existing products may, and new products, including the EMBASSYTrust Server applications will, be subject to reviews by the BXA to determinewhat export classification they will receive. Some of our partners demand thatour products be allowed to be exported without restrictions and/or reportingrequirements. Current export regulations have, in part, allowed us to receivethe desired classification without undue cost or effort. However, the exportregulations may be modified at any time. Currently, we are allowed to exportthe products for which we’ve received classification, in an unrestricted mannerwithout a license. However, modifications to the export regulations couldprevent us from exporting our existing and future products in an unrestrictedmanner without a license. Such modifications could also make it more difficultto receive the desired classification. If export regulations were to bemodified in such a way, we may be put at a competitive disadvantage withrespect to selling our products internationally.

In addition, import and export regulations ofencryption/decryption technology vary from country to country. We may besubject to different statutory or regulatory controls in different foreignjurisdictions, and as such, our technology may not be permitted in theseforeign jurisdictions. Violations of foreign regulations or regulation ofinternational transactions could prevent us from being able to sell ourproducts in international markets. Our success depends in large part to havingaccess to international markets.

**Our stock price isvolatile.**

The price of our Class Acommon stock has been and likely will continue to be subject to widefluctuations in response to a number of events and factors, such as:

·       quarterlyvariations in operating results;

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

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

·       newsreports relating to trends in our markets.

In addition, the stock market in general, and themarket prices for technology-related companies in particular, have experiencedsignificant price and volume fluctuations. These broad market fluctuations mayadversely affect the market price of our Class A common stock or any ofour other securities for which a market develops, regardless of our operatingperformance. Securities class action litigation has often been institutedagainst companies that have experienced periods of volatility in the market pricefor their securities. A Class action lawsuit is currently pending againstus (See “**Class action lawsuits could affect ouroperations”**below);  and it is possible that we could become thetarget of additional litigation of this kind that would require substantialmanagement attention and expense. The diversion of management’s attention andcapital resources could have a material adverse affect on our business. Inaddition, any negative publicity or perceived negative publicity of any suchlitigation could have an adverse impact on our business.

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**We may be subjectto conflicts of interest that could adversely slow our corporate governanceprocess.**

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

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

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

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

**If we make anyacquisitions, we will incur a variety of costs and may never realize theanticipated benefits.**

If appropriate opportunities become available, we mayattempt to acquire businesses, technologies, services or products that webelieve are a strategic fit with our business. We currently have no commitmentsor agreements with respect to any material acquisitions. If we do undertake anytransaction of this sort, the process of integrating an acquired business,technology, service or product may result in operating difficulties andexpenditures and may absorb significant management attention that wouldotherwise be available for ongoing development of our business. Moreover, wemay never realize the anticipated benefits of any acquisition. Futureacquisitions could result in potentially dilutive issuances of equitysecurities, the incurrence of debt, contingent liabilities and/or amortizationexpenses related to certain intangible assets and increased operating expenses,which could adversely affect our results of operations and financial condition.

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

The SEC has commenced a formal investigation intocertain matters relating to Wave. The SEC investigative order relates tocertain public statements made by Wave during and around August 2003, aswell as certain trading in Wave’s securities during such time. The SEC has notconcluded that there has been any wrongdoing and Wave is cooperating fully withthe SEC on this matter. An adverse resolution of the investigation may have anegative effect on our financial condition and operating results.

**Class action lawsuitscould affect our operations.**

A consolidated amended class action complaint ispending in the United States District Court for the District of Massachusetts,naming Wave, its Chief Executive Officer and its Chief Financial Officer asdefendants. Brumbaugh et al. v. Wave Systems Corp. et al., Civ. No. 04-30022(D. Mass.) (MAP). The purported class action has been filed by allegedpurchasers of Wave’s Class A Common Stock during the purported classperiod July 31, 2003 through February 2, 2004. The complaint claimsthat Wave and the named individuals violated Section 10(b) of theSecurities Exchange Act of 1934 (the “1934 Act”), Rule 10(b)-5promulgated thereunder and Section 20(a) of the 1934 Act by publiclydisseminating 

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

Wave intends to defend the action vigorously. Recently,the Court granted in part and denied in part defendants’ motion to dismiss. TheCourt dismissed two but let stand seven alleged misrepresentations or omissions.This is not a finding of fault or liability, it is a decision not entirely todismiss plaintiffs’ pleading. Wave is unable to predict the outcome of thisaction.

A consolidated, purported derivative action waspending in the United States District Court for the District ofMassachusetts,  Sachs v. Sprague et al.Civ. No. 04-30032 (D. Mass.) (MAP) The complaint names all of Wave’s directors during the period July 2003through February 2004 as defendants and alleges claims for breach offiduciary duties and other claims based on allegations similar to the purportedsecurities class action. Wave is also named as a nominal defendant, althoughthe actions are derivative in nature and purportedly asserted on behalf of Wave.On December 22, 2004, Wave moved to dismiss the complaint. The Court heldoral arguments on March 25, 2005. On September 26, 2005, the Courtentered an Order stating that the defendants’ motion to dismiss has beenallowed. On November 22, 2005 the Court issued a memorandum of decisionand entered judgment. The case is terminated in the District Court. However,Plaintiffs have filed a Notice of Appeal. The appeal is proceeding.

At this time, Wave isunable to predict the outcome of this action.

**Item 2. Properties**

Summarizedbelow is a listing of properties leased by Wave. Our principal research anddevelopment activities are conducted at the Princeton and Cupertino facilities.

| **Facility**    | ** ** | ** ** | ** ** | **Sq. Ft.** | ** ** | **Annual  Lease Cost** | ** ** | **Lease Expires** | ** **     |
|-----------------|------------|------------|------------|------------------|------------|-----------------------------|------------|------------------------|----------------|
| Lee, MA         |       | 13,048     |       |             | $          | 126,877                     |       |                   |           | July 2007 |   |   |
| Princeton, NJ   |       | 7,128      |       |             | 157,367    |                        |       |                   | Dec. 2009 |   |   |
| Cupertino, CA   |       | 10,028     |       |             | 275,916    |                        |       |                   | Feb. 2008 |   |   |
| New York, NY    |       | 7,169      |       |             | 377,177    |                        |       |                   | Apr. 2006 |   |   |
| Orvault, France |       | 1,000      |       |             | 67,260     |                        |       |                   | Sept. 2007     |   |   |

 

**Item 3.**                        LegalProceedings

*Securities andExchange Commission Investigation*

On December 17, 2003,Wave received an Order by the Securities and Exchange Commission (the “Commission”)regarding a formal investigation. The focus of this investigation is on certainpublic statements made by Wave during and around August 2003, as well ascertain trading in Wave’s securities during such time. Wave is cooperatingfully with the Commission in this investigation. Wave is unable to predict theoutcome of this investigation at this time.

*Purported Class Actions*

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

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

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

Wave intends to defend theaction vigorously. Recently, the Court granted in part and denied in partdefendants’ motion to dismiss. The Court dismissed two but let stand sevenalleged misrepresentations or omissions. This is not a finding of fault orliability, it is a decision not entirely to dismiss plaintiff’s pleading. Waveis unable to predict the outcome of this action.

*Derivative Actions*

A consolidated, purported derivative action is pendingin the United States District Court for the District of Massachusetts, Sachs v.Sprague et al. Civ. No. 04-30032 (D. Mass.) (MAP). The complaintnames all of Wave’s directors during the period July 2003 through February 2004as defendants and alleges claims for breach of fiduciary duties and otherclaims based on allegations similar to the purported securities class action. Waveis also named as a nominal defendant, although the actions are derivative innature and purportedly asserted on behalf of Wave.

On December 22, 2004,Wave moved to dismiss the complaint. The Court held oral argument on March 25,2005. On September 26, 2005, the Court entered an Order stating that thedefendants’ motion to dismiss has been allowed. On November 22, 2005 theCourt issued a memorandum of decision and entered judgment. The case terminatedin District Court. However, Plaintiffs have filed a Notice of Appeal. The appeal is proceeding. At thistime, Wave is unable to predict the outcome of this action.

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

None.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity and Related Stockholder Matters

*Market Information &Dividends*

The Class ACommon Stock trades on the Nasdaq National Market under the symbol “WAVX”. Thefollowing table sets forth, for the periods indicated, the high and low salesprices per share for the Class A Common Stock. There is no establishedtrading market for our Class B Common Stock.

| ** **                         | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------|------------|----------|------------|---------|------------|
| Year Ended  December 31, 2005 |       |     |       |    |       |
| First Quarter                      |       | $        | 1.27       |    | $          | 0.88 |   |
| Second Quarter                     |       | 0.99     |       | 0.58    |       |
| Third Quarter                      |       | 1.35     |       | 0.76    |       |
| Fourth Quarter                     |       | 0.98     |       | 0.65    |       |
| Year Ended  December 31, 2004 |       |     |       |    |       |
| First Quarter                      |       | $        | 2.34       |    | $          | 1.03 |   |
| Second Quarter                     |       | 2.29     |       | 1.02    |       |
| Third Quarter                      |       | 1.37     |       | 0.71    |       |
| Fourth Quarter                     |       | 1.72     |       | 0.78    |       |

 

As of February 24, 2006 there were approximately28,400 holders of our Class A Common Stock. As of such date, there were 15holders of our Class B Common Stock.

On February 24, 2006 the last sale price reportedon the Nasdaq National Market for the Class A Common Stock was $0.66

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

*SecuritiesAuthorized for Issuance Under Equity Compensation Plans*

Thefollowing pertains to Wave’s equity compensation plans as of December 31,2005:

| **Plan Category**                                                 | ** ** | ** ** | ** ** | **Number of Securities  to be issued upon  exercise of  outstanding options,  warrants and rights  (a)** | ** ** | **Weighted Average  exercise price of  outstanding options,  warrants and rights  (b)** | ** ** | **Number of securities  remaining available  for future issuance  under equity  compensation plans  excluding securities  reflected in   column (a))  (c)** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders                |       |       | 12,420,897 |                                                                                                                                                  |       |                                                                                                                  | $          | 3.81                                                                                                                                                                                                               |       |   |   | 8,324,915 |   |   |
| Wave equity  compensation plans not approved by security holders       |       |       | 174,365    |                                                                                                                                                  |       |                                                                                                                  | 1.92       |                                                                                                                                                                                                               |       |   | — |   |   |
| Total Company plans                                                    |       |       | 12,595,262 |                                                                                                                                                  |       |                                                                                                                  | $          | 3.79                                                                                                                                                                                                               |       |   |   | 8,324,915 |   |   |
| Wavexpress equity  compensation plans not approved by security holders |       |       | 691,896    |                                                                                                                                                  |       |                                                                                                                  | $          | 1.23                                                                                                                                                                                                               |       |   |   | 1,780,327 |   |   |

 

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Wave equitycompensation plans not approved by security holders are comprised of thefollowing:

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

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

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

As a result of the successful placement of 350 sharesof Series B preferred stock, in 1996 a consultant from Digital Media Group, Inc.(“Digital Media”) was issued warrants by Wave to purchase 15,000 shares of Class ACommon Stock at a price of $3.09 per share, pursuant to an individualcompensation plan with Digital Media (the “Digital Media Plan”). No additionalwarrants are required to be granted pursuant to the Digital Media Plan. Thesewarrants were exercisable as of December 31, 2005. Warrants for 5,000shares expired on March 1, 2006. The remaining warrants expire on April 1,2006 through August 1, 2006.

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**Item6.   Selected Financial Data**

**ConsolidatedStatement of Operations Data**

| ** **                                                                                    | ** ** | **For the year-ended December 31,** | ** **  |
|-----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|-------------|
| ** **                                                                                    | ** ** | **2005**                                                | ** **  | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Net Revenues                                                                                  |       | $                                                       | 1,018,464   |   | $ | 209,311 |   | $ | 189,363 |   | $ | 446,588 |   | $ | 692,125 |   |
| Cost of Sales                                                                                 |       | 726,853                                                 |        | 151,704 |   | 55,179 |   | 202,208 |   | 369,959 |   |
| Gross Profit                                                                                  |       | 291,611                                                 |        | 57,607 |   | 134,184 |   | 244,380 |   | 322,166 |   |
| Operating expenses:                                                                           |       |                                                    |        |   |   |   |   |   |   |   |   |
| Selling, general and  administrative                                                          |       | 11,560,039                                              |        | 12,255,427 |   | 12,698,682 |   | 19,188,046 |   | 24,184,317 |   |
| Research and development                                                                      |       | 6,937,618                                               |        | 6,852,754 |   | 7,384,708 |   | 12,009,713 |   | 17,691,051 |   |
| Restructuring and other  special  charges                                                     |       | —                                                  |        | — |   | — |   | 726,280 |   | — |   |
| Amortization of goodwill                                                                      |       | —                                                  |        | — |   | — |   | — |   | 1,720,632 |   |
| Inventory provision                                                                           |       | —                                                  |        | — |   | 1,114,442 |   | — |   | — |   |
| Write-off of goodwill                                                                         |       | —                                                  |        | — |   | — |   | — |   | 2,284,570 |   |
| Write-off of intangible  and other impaired assets                                            |       | —                                                  |        | 301,366 |   | — |   | 1,571,031 |   | 1,761,917 |   |
|                                                                                          |       | 18,497,657                                              |        | 19,409,547 |   | 21,197,832 |   | 33,495,070 |   | 47,642,487 |   |
| Other income (expense):                                                                       |       |                                                    |        |   |   |   |   |   |   |   |   |
| Equity in net losses of  GlobalWave                                                           |       | —                                                  |        | — |   | — |   | — |   | (2,332,159 | ) |
| Loss on other than  temporary decline in equity securities                                    |       | —                                                  |        | — |   | — |   | (11,513,099 | ) | (1,736,682 | ) |
| Liquidated damages                                                                            |       | —                                                  |        | — |   | (155,716 | ) | — |   | — |   |
| Gain on decrease in value  of warrant liability                                               |       | 490,334                                                 |        | 498,723 |   | 263,097 |   | — |   | — |   |
| Gain on termination of  development contract                                                  |       | —                                                  |        | — |   | — |   | 1,818,000 |   | — |   |
| Recovery of (Provision  for loss on) officer note receivable                                  |       | —                                                  |        | — |   | 999,518 |   | (999,518 | ) | — |   |
| Gain on sale of  marketable securities                                                        |       | 80,971                                                  |        | 4,330,248 |   | 234,759 |   | — |   | — |   |
| Net interest and other  income  (expense)                                                     |       | 72,279                                                  |        | 24,931 |   | 127,192 |   | 477,902 |   | 2,688,105 |   |
| Total Other Income  / (expense)                                                               |       | 643,584                                                 |        | 4,853,902 |   | 1,468,850 |   | (10,216,715 | ) | (1,380,736 | ) |
| Net loss                                                                                      |       | (17,562,462                                             | )           | (14,498,038 | ) | (19,594,798 | ) | (43,467,405 | ) | (48,701,057 | ) |
| Accrued dividends  on preferred stock (including $5,485,000 of accretion of discount in 2003) |       | —                                                  |        | — |   | 5,697,518 |   | — |   | — |   |
| Net loss to common  stockholders                                                              |       | $                                                       | (17,562,462 | ) | $ | (14,498,038 | ) | $ | (25,292,316 | ) | $ | (43,467,405 | ) | $ | (48,701,057 | ) |
| Weighted average  number of common shares outstanding during the period                       |       | 83,178,663                                              |        | 69,040,661 |   | 55,887,384 |   | 51,135,548 |   | 49,949,875 |   |
| Loss per common  share-basic and diluted                                                 |       | $                                                       | (0.21       | ) | $ | (0.21 | ) | $ | (0.45 | ) | $ | (0.85 | ) | $ | (0.97 | ) |
| Cash dividends  declared per common  share                                                    |       | -0-                                                     |        | -0- |   | -0- |   | -0- |   | -0- |   |

 

**ConsolidatedBalance Sheet Data**

| ** **                                   | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Working capital                              |       | $                                     | (1,112,413 | ) | $ | 3,549,095 |   | $ | 12,406,861 |   | $ | 8,754,620 |   | $ | 36,963,617 |   |
| Total assets                                 |       | 3,429,765                             |       | 8,454,582 |   | 18,160,430 |   | 18,209,372 |   | 60,234,302 |   |
| Long-term liabilities                        |       | 2,794                                 |       | 493,128 |   | 991,851 |   | — |   | — |   |
| Total liabilities                            |       | 3,595,574                             |       | 3,744,382 |   | 4,145,794 |   | 3,667,533 |   | 6,428,896 |   |
| Total stockholders’ equity (deficiency) |       | $                                     | (165,809   | ) | $ | 4,710,200 |   | $ | 14,014,636 |   | $ | 14,541,839 |   | $ | 53,805,406 |   |

 

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**Item7.**   Management’s Discussion and Analysisof Financial Condition and Results of Operations

**Overview**

In 2003 Wave’s managementmade a shift in its business focus by devoting less attention and resource toits proprietary EMBASSY Trust System and more attention to developing andmarketing TCG-compliant software products known as its EMBASSY Trust Suite andEMBASSY Trust Server Applications. These are products designed and built aroundthe TCG specifications, known as Trusted Platforms, that are being adopted intothe Information Security Services marketplace. Wave devoted a substantialamount of its activities and resources during the year ended December 31,2003 to organizing its business to capitalize on the opportunities presented bythe emergence of the TCG specifications.

In2004 and 2005, Wave continued to pursue a strategy of educating the marketplaceon the benefits that trusted computing has to offer, while continuing todevelop the basic software applications designed to enable this emergingtechnology. The market trends and opportunities that management focused thecompany’s activities during the year ended December 31, 2005 included thefollowing:

·       Anew study by Infonetics forecasts sharp rises in end-point security. The studypredicts that in the coming years, endpoint security will require a range ofnew types of software and hardware to be effective, including endpoint-securityappliances and improved network-infrastructure equipment. Accordingly, thestudy forecasts the overall network access control (NAC) enforcement marketwill grow to $3.9 billion by 2008, up from just $323 million last year, a 1101%increase. More information is available from the IT Compliance Institute.

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

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

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

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

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

·       Inits *Windows Vista Logo Program for Systems, Version3.0, Draft Revision 0.7*, Microsoft has required TPM version 1.2 inits draft operating system hardware requirements specification for logocompliance for “Gold” level business PCs. Wave believes that a significantpercentage of the approximately 150 million unit PC market will include TPMs byDecember 2006, which is Microsoft’s stated launch date for Vista.

·       Theemergence of additional trusted PC components, such as Seagate’s Momentus 5400Full Disc Encryption drive which was announced in Q3 of 2005, representadditional opportunities for Wave’s products to support and integrate thesedevices with the TPM elements in the PC.

·       OnFebruary 3, 2006, the  U.S. Army, inthe new Consolidated Buy-2 (CB2) Desktop and Notebook minimumspecifications for Army customers as published by the Army Small ComputerProgram, specifies the requirement for desktop and laptop personal computers tobe equipped with new open security chip hardware called the Trusted PlatformModule (TPM).

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

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

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

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

·       Limitedavailability of capital resources—Wave continues to rely on financing thedevelopment of its business by issuing new equity (See **Liquidityand capital resources**section for a detailed discussion of financingactivities during 2005).

As more PC and chip OEMshave begun introducing their Trusted Platform offerings, management has focusedon entering into licensing contracts in which the OEM licenses our applicationsand bundles them with their offering, paying Wave a royalty for each unitshipped. Wave currently has signed such bundling agreements with three separateOEM partners. For the year ended December 31, 2005, Wave receivedapproximately $865,000 in royalties from these OEM partners pursuant to itslicense agreements with them. Revenue recognized on these contracts through December 31,2005 totaled approximately $757,000, while the remaining $108,000 is includedin deferred revenue.  We continue topursue OEM business under the royalty model described herein. In addition, weseek to enter into arrangements with resellers that sell to PC OEMs todistribute our applications as a product offering that users may choose whenpurchasing a TPM-equipped computer from the PC OEM. In February, 2005, DellComputers Inc began offering Wave’s ETS Software as an option for purchase onselect models through their website at Dell.com and in December 2005 Wavesigned a distribution license agreement with Dell pursuant to which Dell ispermitted to ship a version of Wave’s EMBASSY Trust Suite software withselect Dell PC models. Wave is entitled to royalties on each unit that shipswith Wave software and a fully featured version of ETS will be offered to Dellcustomers as an upgrade which will generate additional license revenue for Wavewhen customers elect to purchase the upgrade. Wave hopes to capitalize on thisassociation with Dell products and the wider distribution of TPM-equippedpersonal computers that a Dell TPM offering represents. However, there are nominimum royalty or shipped quantity requirements. In addition, we have soughtto develop our products such that they operate on all of the major PC OEMTrusted Platforms that are currently shipping product in the marketplace andour applications have been approved to work with the Trusted Platforms of IBM,HP, Atmel, Infineon and others.

Management is also focusedon developing the client and server-side applications and tools that willenable enterprises to manage an IT infrastructure that relies on products builtusing TCG specifications. Wave is devoting a significant portion of itsresearch and development budget to address this opportunity, as this will be akey ingredient for enterprises in successfully implementing a Trusted Platformsolution. Wave released these tools and applications in 2004, and has signed alicense agreement in 2005 with a small number of enterprise customers tolicense the Wave TCG-enabled toolkit, EAS and EKMS..

With respect to sales andmarketing, management is focused on broadening our distribution strategies toinclude the direct engagement of our channel partners using their resellers andsystems integrators and has hired regional representation in Japan. We havealso expanded our targeted presence selling directly to OEMs. We havespecifically focused our resources towards solution selling in these channels. Anexample of building a channel partner relationship is the memorandum ofunderstanding that Wave signed with NTT Data Corporation (“NTT”), a Japaneseinformation technology systems integrator, pursuant to which Wave and NTTenvision the formation of a distributor and systems integrator relationship toresell Wave’s products and solutions and to provide support services to NTTscustomers in an effort to introduce such products and solutions to the Japaneseenterprise market..

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Management is also focusedon opportunities for its eTMS product suite to provide digital signing anddocument management solutions to the financial services and other verticalmarkets in which there is a clear and identifiable value proposition inimplementing these solutions. Although we have met significant implementationchallenges and long sales cycles with this effort, we have also entered intocontracts with a la mode, inc. in the real estate industry in 2004 and withEfficient Forms, LLC in the financial services sector in 2005. We continue topursue additional opportunities for the eTMS product line.

Wavexpress is focused onbuilding a sustainable revenue stream by establishing partnerships withbranded content providers to provide paid and advertising supported videoentertainment services. Wavexpress’ TVTonic service has recently added newcontent partners and has been designed to support any video channel distributedvia RSS. RSS is the standard format for blogs and podcasts and is beingincreasingly used for open video distribution on the Internet. It is intendedthat TVTonic will be an advertising supported service. TVTonic is currentlybeing promoted with all Microsoft Media Center Edition PCs through their OnlineSpotlight partner program. In addition, Wavexpress is extending its technologyso that its subscriber management system can leverage the added security of aTPM and is preparing back-office systems for standalone deployment intoenterprise installations.

Wavexpress currently hastwo active contracts that are generating revenue going into 2006. It isexpected that these contracts will generate revenue that is in line with therevenue that Wavexpress has generated in 2005. Management plans to devoteincreasing development resources towards building its feature set to meetmarket demand.

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

*Operating Expense Trends*

While research and developmentexpenses increased slightly from 2004 to 2005 as shown in Item I—Business;selling, general and administrative expenses (“SG&A”) have been trendingdownward over the three years ended December 31, 2005. For the years endedDecember 31, 2005, 2004 and 2003 we have incurred approximately $11.6million, $12.3 million and $12.7 million, in SG&A expenses, respectively. Theactivities supported by these expenditures include business development, sales,marketing (including product management), corporate communications and publicrelations, information technology and management information systems, humanresources, accounting, executive management, corporate governance and generaladministrative functions. The downward trend in SG&A expenses and expenses ingeneral, is indicative of Wave’s strict cost-cutting measures, which beganduring the second half of 2001 and continued through the end of 2003, and havesince flattened into 2004 and in 2005 which showed a much lower rate ofdecrease. Much of these cost reductions were the result of Wave’s abandonmentof several lines of business that it had previously been pursuing, includingInternet services and consumer e-commerce. In addition, Wave de-emphasized themarketing of its proprietary EMBASSY Trust System platform in 2003 other thanto the government security sector. While Wave adjusted its emphasis to focus onthe emerging TCG services market segment toward the end of 2002 and into 2003,it drastically reduced several areas within the selling, general andadministrative category including product management, sales and marketing,business development and support areas including accounting, human resources,information systems and other corporate overhead, that had supported the higherlevel of business activity that has now been reduced. The expense reductionsbeing referred to herein came mostly in the form of headcount and outsideservices expenditure reductions. Now that Wave has begun selling its suite ofsoftware applications into the market and has identified and begun developingthe next generation of these products that will include key management andinfrastructure services, we’ve begun rebuilding our sales force, expanding ourdistribution channels and implementing a global sales and marketing strategy.

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Although we’ve reduced our expenditures significantly,given the early stage nature of the markets for products that use ourtechnology, we will continue to expend considerable resources in the sales,marketing, business development and support activities referred to above thatwill be necessary for us to be successful in developing salable products andmarkets for our technology. The outlook over the short-term is for sales andmarketing expenditures to remain relatively flat, compared with 2005, with researchand development remaining at approximately the same level as 2005 as well. (See**Liquidity and capital resources**)

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

**Critical Accounting Policies**

Wave’s discussion and analysis of its financialcondition and results of operations are based on the Company’s consolidatedfinancial statements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America. The preparation of thesefinancial statements requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and the disclosure ofcontingent assets and liabilities at the date of the financial statements, aswell as the reported revenues and expenses during the reporting periods. On anongoing basis, management evaluates its estimates and judgments, includingthose related to revenue recognition, accounts receivable reserves, marketablesecurities, valuation of long-lived and intangible assets, accounting for jointventures and software development. Management bases its estimates on historicalexperience and on various other factors that are believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying value of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

The followingaccounting policies are deemed critical to the understanding of theconsolidated financial statements included under Item 8—Financial Statementsand Supplementary Data.

*Method ofAccounting for Joint Ventures—*Waveaccounts for its investments in joint ventures using the equity method ofaccounting when its ownership interest in the joint venture is less than fiftypercent and it is determined that Wave has the ability to exercise significantinfluence over the joint venture’s operating and financial policies. Thefinancial statements of joint ventures in which Wave owns greater than afifty-percent interest are consolidated with Wave’s financial statementspursuant to Accounting Principles Board (“APB”) Opinion No. 18.

*MarketableSecurities—*Investments, whichconsist solely of equity securities, are accounted for under Statement ofFinancial Accounting Standards (SFAS) No. 115, “Accounting for CertainInvestments in Debt and Equity Securities” issued by the Financial AccountingStandards Board (FASB). Pursuant to the provisions of SFAS No. 115,investments are classified as “trading”, “available-for sale” or “held tomaturity”. “Trading” securities are bought and held principally for the purposeof selling them in the near term and are recorded at fair value. Fair value isbased upon quoted market prices. Unrealized gains and losses on tradingsecurities are included in the determination of net earnings.“Available-for-sale” securities are being held for an unspecified period oftime and may be used for liquidity or other corporate purposes and are recordedat fair value. Unrealized gains and losses on available-for-sale securities arereported as a separate component of comprehensive income (loss) in stockholders’equity. Unrealized losses that are determined to be other than temporary arerecognized as charges against earnings. Factors considered when determining ifan other than temporary decline has occurred include: whether a decline inmarket value is related to specific concerns of the issuer of the securities asopposed to general market conditions, the length of time of the decline inmarket price, the financial condition and near-term prospects of the issuer andother factors that may indicate that the value of the securities will notrecover. 

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*“Held tomaturity” securities are debt securities that are intended to be held tomaturity and are recorded at amortized cost*. As of December 31,2004, all of Wave’s marketable equity securities were classified as available-for-sale.Wave held no marketable securities as of December 31, 2005.

*Research andDevelopment and Software Development Costs—*Research and development costs are expensed asincurred. Software development costs are accounted for pursuant to Statement ofFinancial Accounting Standards No. 86 “Accounting for the Costs ofComputer Software to be Sold, Leased, or Otherwise Marketed” (“SFASNo. 86”). SFAS No. 86 specifies that costs incurred internally increating a computer software product should be charged to expense when incurredas research and development costs until technological feasibility has beenestablished for the product. Once technological feasibility is established andthe product has achieved commercial marketability, all development costs shouldbe capitalized until the product is available for general release to customers.We consider technological feasibility to be established upon completion of adetail program design, or in the absence of a detail program design, uponcompletion of a working model of the software as defined in SFAS No. 86.Judgment is required in determining when the technological feasibility of aproduct is established, if the product has achieved commercial marketabilityand in estimating the life of the product for which the capitalized costs willbe amortized.

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

·       significantunderperformance relative to expected historical or projected future operatingresults;

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

·       significantnegative industry or economic trends; and

·       significantdecline in our stock price for a sustained period.

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

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

Wave follows theprovisions of statement of position SOP 97-2, Software Revenue Recognition asamended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition,with Respect to Certain 

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Transactions.Generally, Wave recognizes revenue when it is realized or realizable andearned. Wave considers revenue realized or realizable and earned whenpersuasive evidence of an arrangement exists, delivery has occurred, the salesprice is fixed or determinable and collectibility is reasonably assured. Wavereduces revenue for estimated customer returns, rotations and sales rebateswhen such amounts can be estimated. When these amounts cannot be estimated Wavedefers revenue until the product is sold to the end-user. Revenue from softwarelicense agreements that have significant customizations and modification of thesoftware product is deferred and recognized in a manner that approximates thepercentage of completion method. In addition to the aforementioned generalpolicy, the following are the specific revenue recognition policies for eachmajor category of revenue.

*PRODUCTS—SOFTWARE*

Revenue from delivered elements of one-time chargelicensed software is recognized at the inception of the license term, providedWave has vendor-specific objective evidence of the fair value of eachundelivered element, for arrangements that contain multiple elements. Revenueis deferred for undelivered elements for these arrangements. Revenue is alsodeferred for the entire arrangement, if vendor-specific objective evidence doesnot exist for each undelivered contract element. Examples of undeliveredelements in which the timing of delivery is uncertain include contractualelements that give customers rights to any future upgrades at no additionalcharge or future maintenance that is provided within the overall price. Therevenue that is deferred for any contract element is recognized when all of therevenue recognition criteria have been met for that element.

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

*SERVICES*

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

**Comparisonof the years ended December 31, 2005 and 2004**

*Results ofOperations*

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

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

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

 

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

SG&A expenses on a consolidated basis for the yearended December 31, 2005 were $11,560,039, as compared to $12,255,427 forthe comparable period of 2004, a decrease of approximately 6%. The decrease wasdue in large part to decreases in salary and benefit costs totalingapproximately $363,000 on a consolidated basis, associated with headcountreductions of four S&GA positions at Wavexpress which were made in thefourth quarter of 2004. In addition, depreciation and amortization expense waslower by approximately $637,000, because amortization that was previouslyincluded in SG&A for the year ended December 31, 2004, related torevenue and was therefore included in cost of sales for the year ended December 31,2005.  These expense decreases wereoffset by increases in travel & entertainment expenses of $107,200 atWave; due to increased international sales and marketing activities; andincreases in bonuses and commissions of $167,200 in connection with the highersales volume for the year ended December 31, 2004 versus the prior year.Included in the consolidated SG&A expense totals listed above areWavexpress’ SG&A expenses, which were $1,096,335 and $1,789,997 for theyears ended December 31, 2005 and 2004, respectively. This 39% decreasewas due primarily to decreased salary, benefit, travel and otheremployee-related expenses which accounted for approximately $481,000 of thedecrease in the consolidated salary and benefit expenses referred to above. Inaddition, Wavexpress’ facility, broadband and telecommunications expenses werereduced by approximately $50,000, consultant and professional fees were reducedby approximately $33,000, depreciation expenses decreased by approximately$43,000, and general office and supplies expenses were reduced by $35,000.

The activities supported by Wave’s SG&Aexpenditures include business development, sales, marketing (including productmanagement), corporate communications and public relations, informationtechnology and management information systems, human resources, accounting,executive management, corporate governance and general administrative functions.Given the early stage nature of the****markets forproducts that use our technology, we have expended and will continue to expendconsiderable resources, in the sales, marketing, business development andsupport activities referred to above that will be necessary for us to besuccessful in developing products and markets for our technology. We expectSG&A expenses to remain approximately at the same level as the year December 31,2005 for the foreseeable future, although actual expenditures may varydepending upon the future business needs of Wave.

R&D expenses for the year ended December 31,2005 were $6,937,618, as compared to $6,852,754, for year ended December 31,2004, an increase of 1%. This change was primarily attributable to increasedsalary, fringe and benefit expenditures of approximately $311,000 at Wave whereR&D headcount was greater by an average of three positions in the yearended December 31, 2005 versus 2004.  In addition, outside consulting anddevelopment expenses increased by approximately $291,000 at Wave as Waveincreased the use of outsourced engineering services primarily in connectionwith its eTMS products and services. Wavexpress’ total R&D expendituresincluded in the above consolidated R&D expenses were $1,127,004 and$1,657,376, for the year ended December 31, 2005 and 2004, respectively,for a decrease of approximately 32% This decrease related primarily to salaryand fringe benefit cost reductions of approximately $475,000 due to a reductionin headcount of six positions on average, for the year ended December 31,2005 versus the prior year.

In the year ended December 31,2004, Wave took a charge of $301,366 to write-off developed software that hadbeen capitalized. The software that was written off was developed for adistribution agreement that was entered into with NSC, whereby NSC was todistribute it with its trusted platform model chip. The write-off was theresult of the termination of the agreement and because the version of thesoftware that was written off was discontinued and superseded by a new version.Consequently, the 

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value ofthe software became impaired because it had no alternative uses. No suchimpairment charges were incurred in the year ended December 31, 2005. Wavecontinues to maintain a license agreement with NSC’s successor, Winbond,whereby Wave is paid royalties based on Wave intellectual property that isincluded in Winbond’s chip design.

*Other Income andExpenses*

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

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

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

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

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

*Results ofOperations*

Forthe year December 31, 2004 and December 31, 2003, revenues were$209,311 and $189,363, respectively. The increase in revenue is attributable toincreases in product, and licensing revenue offset by a decrease in servicerevenues, as set forth in the following table:

| ** **         | ** ** | **2004** | ** ** | **2003** | ** ** | **Increase/  (Decrease)** | ** ** | **% Change** | ** ** |
|--------------------|------------|----------|------------|----------|------------|---------------------------|------------|-------------------|------------|
| Licensing          |       | $        | 183,318    |     | $          | 120,670                   |       |              | $          | 62,648 |   |   |   | 51.9 | % |   |
| Services           |       | 18,833   |       | 65,343   |       |                      | (46,510    | )                 |       |   | (71.2 | )% |   |
| Hardware products  |       | 7,160    |       | 3,350    |       |                      | 3,810      |              |       |   | 113.7 | % |   |
| Total Net Revenues |       | $        | 209,311    |     | $          | 189,363                   |       |              | $          | 19,948 |   |   |   | 10.5 | % |   |

 

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

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SG&A expenses for the year December 31, 2004were $12,255,427 as compared to $12,698,682 for the comparable period of 2003. The3% decrease in selling, general and administrative expenses was attributableprimarily to headcount reductions at both Wave and Wavexpress. Wavexpressincurred SG&A expenses of $1,789,997 in 2004, compared to $2,014,828 for2003, for a decrease of 11%. The reasons set forth above encompass Wavexpress,as well as Wave as a whole.

Research and development expenses for the year ended December 31,2004 were $6,852,754 as compared to $7,384,708 for the comparable period of2003. This 7% decrease in research and development expenses was primarilyattributable to headcount reductions of employees and consultants, whichdecreased expenses by a total of $640,928 including salary and consultantcompensation.   Wavexpress’ research anddevelopment expenses were $1,657,376 for the year ended December 31, 2004versus $1,873,463, for a reduction of 12%. The amounts set forth for Wavexpressare included in the consolidated amounts referred to above. Also, the reasonsfor the reduction in expenditures set forth above pertain to both Wave as awhole and Wavexpress.

For the year ended December 31, 2004, Wave took acharge of $301,366 to write-off developed software that had been capitalized. Thesoftware that was written off was developed for a distribution agreement thatwas entered into with NSC, whereby NSC was to distribute it with their trustedplatform module chip. The write-off was the result of the termination of theagreement and because the version of the software that was written off has beendiscontinued and superseded by a new version. Consequently, the value of thesoftware became impaired because it had no alternative uses. No such impairmentcharges were incurred in the year ended December 31, 2003. Wave continuesto maintain a license agreement with NSC, whereby Wave is paid royalties basedon Wave technology that is included in NSC’s chip design.

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

*Other Income andExpenses*

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

Wave sold 2,507,300 shares of its holdings of SSPSolutions, Inc., common stock and 966,300 shares of Saflink Corporationcommon stock during the year ended December 31, 2004, for total proceedsof $6,759,751, recording a realized gain of $4,330,248 on the sales. In August,2004, SSP Solutions, Inc. merged with and became a wholly-owned subsidiaryof Saflink Corporation. For the year ended December 31, 2003, Wave sold332,500 shares of SSP for proceeds of $430,934, realizing an aggregate gainfrom the sales of $234,759.

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

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purchaser equal to 2% ofeach purchaser’s subscription amount, for each month elapsed beyond the 30 daydeadline. Because Wave was not able to file the registration statement untilone month and three days after the 30 day deadline, Wave incurred an aggregateof $155,716 in liquidated damages in the fourth quarter of 2003. No suchcharges were incurred in 2004.

For the year ended December 31, 2004, Wave recordedincome of $498,723 representing the decrease in the value of the liability foroutstanding warrants containing net cash settlement features. These warrantswere granted in connection with a private placement of Class A CommonStock completed on November 18, 2003. The liability, calculated using theBlack Scholes option pricing model, was valued at $991,851 as December 31,2003, versus $493,128 as of December 31, 2004. The decrease was the resultof the decrease in the quoted closing price on the Nasdaq National Exchange ofWave’s Class A Common Stock from December 31, 2003 to December 31,2004. Because the price of Wave’s Class A Common Stock declined, the fairvalue of the warrants declined as well resulting in the gain. A  gain of $263,097 was recognized for the yearended December 31, 2003 due to the decrease in the fair market value ofthe warrant from the inception of the warrant through December 31, 2003.

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

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

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

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**Liquidity and capital resources**

We have experienced netlosses and negative cash flow from operations since our inception and, as ofDecember 31, 2005, had a deficit accumulated during the development stageof $284,746,826. Total stockholders’ equity as of December 31, 2005 wasnegative $165,809. We have financed our operations since inception principallythrough the issuance of Class A and B Common Stock and various series ofpreferred stock, for total proceeds since inception of approximately $246,281,191.

*Sources and Uses ofCash*

At December 31, 2005, we had $2,006,022 in cashand cash equivalents versus $5,805,912 as of December 31, 2004, resultingin a net decrease in cash of $3,799,890 for the year ended December 31,2005.  The table below shows the year-to-yearcomparison of the significant elements of cash used in operating, investing andfinancing activities and a reconciliation of each year’s operating resultsreported in the statement of operations to the total decrease in cash in eachof the three years ended December 31, 2005.

As shown below, the totalnet decrease in cash over the last three years has changed significantly from anet cash decrease for the year ended December 31, 2003 of $1,402,819 to anet cash decrease for the year ended December 31, 2004 of $3,012,393 to anet cash decrease for the year ended December 31, 2005 of $3,799,890. 

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**ConsolidatedStatement of Cash Flow Data**

| ** **                                                                    | ** ** | **For the years ended December 31,** | ** **  |
|-------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                                    | ** ** | **2005**                                                      | ** **  | **2004** | ** ** | **2003** | ** ** |
| Cash used in operating  activities:                                           |       |                                                          |        |   |   |   |   |
| Net loss                                                                      |       | $                                                             | (17,562,462 | ) | $ | (14,498,038 | ) | $ | (19,594,798 | ) |
| (Recovery of)  provision for note receivable from officers                    |       | —                                                        |        | — |   | (999,518 | ) |
| Realized gain  from the sale of marketable securities                         |       | (80,971                                                       | )           | (4,330,248 | ) | (234,759 | ) |
| Gain on decrease  in value of warrant liability                               |       | (490,334                                                      | )           | (498,723 | ) | (263,097 | ) |
| Write off  intangible and other assets that became impaired                   |       | —                                                        |        | 301,366 |   | — |   |
| Inventory  provision                                                          |       | —                                                        |        | — |   | 1,114,442 |   |
| Depreciation and  amortization                                                |       | 841,729                                                       |        | 854,629 |   | 1,241,035 |   |
| Compensation paid  in the form of stock options & warrants      |       | 7,294                                                         |        | 80,609 |   | 189,565 |   |
| Total adjustments  to reconcile net loss to cash used in operating activities |       | 277,718                                                       |        | (3,592,367 | ) | 1,047,668 |   |
| Proceeds from liquidation of other assets                                     |       | 23,935                                                        |        | 93,570 |   | 50,688 |   |
| (Increase)  decrease in prepaid expenses and receivables                      |       | (201,788                                                      | )           | (67,085 | ) | 368,844 |   |
| (Reduction)  increase in deferred revenue                                     |       | 152,440                                                       |        | 276,968 |   | 74,222 |   |
| (Reduction)  increase in accounts payable and accrued expenses                |       | 189,086                                                       |        | 63,540 |   | (567,853 | ) |
| Changes in  assets & liabilities                                     |       | 163,673                                                       |        | 366,993 |   | (74,099 | ) |
| Other accrual to  cash adjustments, net                                       |       | —                                                        |        | (31,480 | ) | 144,793 |   |
| Cash used in  operating activities                                            |       | (17,121,071                                                   | )           | (17,754,892 | ) | (18,476,436 | ) |
| Cash flows from  investing activities:                                        |       |                                                          |        |   |   |   |   |
| Disbursements for capital expenditures                                        |       | (160,829                                                      | )           | (304,172 | ) | (985,146 | ) |
| Proceeds provided by sales of marketable equity  securities                   |       | 336,309                                                       |        | 6,759,751 |   | 430,934 |   |
| Net cash provided by (used in) investing activities                           |       | 175,480                                                       |        | 6,455,579 |   | (554,212 | ) |
| Cash flows from  financing activities:                                        |       |                                                          |        |   |   |   |   |
| Proceeds from sale of common stock                                            |       | 10,622,054                                                    |        | 8,252,625 |   | 6,562,180 |   |
| Proceeds from sale and conversion of preferred stock                          |       | —                                                        |        | — |   | 4,780,540 |   |
| Proceeds from exercise of employee stock options                              |       | 354,047                                                       |        | 34,295 |   | 2,868,916 |   |
| Proceeds from the exercise of warrants                                        |       | 2,169,600                                                     |        | — |   | 2,493,390 |   |
| Total proceeds  from issuance of newly issued equity                          |       | 13,145,701                                                    |        | 8,286,920 |   | 16,705,026 |   |
| Proceeds from  repayment of officer notes receivable                          |       | —                                                        |        | — |   | 1,135,320 |   |
| Payment of  dividends on preferred stock                                      |       | —                                                        |        | — |   | (212,517 | ) |
| Total cash  provided by financing activities                                  |       | 13,145,701                                                    |        | 8,286,920 |   | 17,627,829 |   |
| Net decrease in cash                                                          |       | $                                                             | (3,799,890  | ) | $ | (3,012,393 | ) | $ | (1,402,819 | ) |

 

*Cash used inoperations*

The amount of cash used inoperations decreased to $17,121,071 for the year ended December 31, 2005from $17,754,892 used for the year ended December 31, 2004, whichdecreased from $18,476,436 used for the year ended December 31, 2003. Asshown above, the decreases in cash used in operations were the result of thechanges in the Net Losses in each of the three years ended December 31,2005, as discussed in detail in the previous *Results ofOperations* section, adjusted for non-cash items of the net lossessuch as book realized gains on sales of marketable securities and changes toassets and liabilities for 

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net cashoutlays and/or receipts which under generally accepted accounting principles,are not reported in the Statement of Operations.

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

These amounts representitems reported in Wave’s Consolidated Statement of Operations, that do notrepresent an outlay or receipt of cash in the year that they are reported,under generally accepted accounting principals. These items in the aggregatemake up a significant portion of the differences between the reductions in Wave’sreported Net Loss year over year, versus the differences in the amount of cashused by Wave’s operations over each of the periods. These items resulted in anet add-back to net loss of $277,718 for the year ended December 31, 2005versus a net subtraction of $3,592,367 for the year ended December 31,2004 compared with a net add-back of $1,047,668 for the year ended December 31,2003. The individual items that make up these adjustments are listed in thetable above and described in greater detail in the *Results ofOperations* and *Other Income and Expense*sections above. In addition, changes in asset and liability accounts, as shownabove, represent additional sources or uses of cash in each of the three years.Accordingly, while the overall net loss increased by $3,064,424 (to $17,562,462from $14,498,038 ) for the year ended December 31, 2005  versus the year ended December 31, 2004,cash used in operating activities decreased by $633,821 (to $17,121,071 from$17,754,892.)  This was due in large partto the gain realized on the sales of available-for-sale securities of $80,971in 2005 versus $4,330,248 in 2004. The gains are subtracted from the reportednet loss to arrive at cash used by operating activities because sales ofmarketable securities are  an investingactivity, therefore the gross proceeds from these sales are shown in Cash Flowsfrom Investing Activities. In comparing the year ended December 31, 2004to 2003, while the overall Net Loss decreased by $5,096,760 (to $14,498,038from $19,594,798) for the year ended December 31, 2004 versus the yearended December 31, 2003, cash used in operating activities decreased bythe lesser amount of $730,544  (to$17,745,892 from $18,476,436.)  This differencewas in large part due to the gain realized on the sales of available-for-salesecurities of $4,330,248 in 2004 versus $234,759 in 2003 coupled with thedifferences between the other adjustments listed above.

*Cash Flows frominvesting activities*

As displayed in the table above, cash used ininvesting activities consisted of funds used to acquire and develop capitalassets totaling $160,829, $304,172 and $985,146 for the years ended December 31,2005, 2004 and 2003, respectively. Such amounts included the cost of internallydeveloped capitalized software in the amount of $0, $73,000, and $580,543 foreach of the three years ended December 31, 2005, 2004 and 2003,respectively. Wave expects to continue to acquire fixed assets primarily toreplace computer equipment to be used internally. These expenditures areexpected to continue at approximately the same level as the 2005 expenditures.

During the year ended December 31, 2005, Wavesold 259,670 shares of Saflink, in a series of separate sales, for totalproceeds of $336,309. For the year ended December 31, 2004, Wave sold2,507,300 shares of the common stock of SSP and 966,330 shares of Saflink fortotal proceeds of $6,759,751. For the year ended December 31, 2003, Wavesold 332,500 shares of SSP common stock for proceeds of $430,934. Wave holds noshares of Saflink as of December 31, 2005.

Net cash generated frominvesting activities decreased by $6,280,099 for the year ended December 31,2005 versus the year ended December 31, 2004 and increased by $7,009,791for the year ended December 31, 2004 versus the year ended December 31,2003. The cash generated from the sale of marketable securities was a much moresignificant source of cash for Wave in 2004, versus the years ended December 312005 and 2003, which made up for much of the differences described herein,combined with lower capital expenditures in each of the two years ended December 31,2005 and 2004 versus 2003.

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*Cash Flows fromfinancing activities*

Because Wave did not havesufficient cash on hand, nor did it generate sufficient revenues to fund theamount of cash used for operations and acquisition and development of capitalassets for the years ended December 31, 2005 and 2004, we needed tofinance much of our operations through the sale of newly issued common stock asdescribed below. In addition, during 2003, Wave received funds from therepayment of notes receivable with an officer and a former officer of Wave thattotaled $1,135,320, including $281,000 that was repaid with the proceeds of a bonusthat was awarded to the officer to repay his loan.

*Proceeds fromIssuance of Newly Issued Equity Securities*

*Sales of CommonStock*

On December 5, 2005, Wave sold and issued5,982,906 shares of Class A Common Stock for $0.585 per share, for grossproceeds of $3,500,000, for which it received net proceeds of $3,340,890 afterpaying underwriter and other fees, which totaled $159,110. The purchasers werealso issued warrants to purchase 1,093,750 shares of Common Shares within sixmonths at an exercise price of $0.80 per share. If exercised in their entirety,the warrants would generate an additional $875,000 in gross proceeds to Wave.

On August 5, 2005, Wave sold and issued 4,000,000shares of Class A Common Stock for $0.90 per share, for gross proceeds of$3,600,000, for which it received net proceeds of $3,389,205 after payingunderwriter and other fees, which totaled $210,795.

On March 15, 2005, Wave sold 4,659,090 shares of Class ACommon Stock for $0.88 per share, for gross proceeds of $4,100,000, for whichit received $3,891,959, after paying underwriter and other fees.

On December 16, 2004, Wave sold and issued5,484,790 shares of Class A Common Stock for an aggregate purchase priceof $5,759,030. The Common Shares were priced at $1.05. Wave realized netproceeds of $5,474,728 after deducting placement agent and other feesassociated with the issuance of these securities.

On July 30, 2004, Wave entered sold and issued3,529,412 shares of Class A Common Stock for an aggregate purchase priceof $3,000,000. The shares of Class A Common Stock were priced at $0.85. Waverealized net proceeds of $2,777,897 after deducting placement agent and otherfees associated with the issuance of these securities. In addition, a total of3,529,412 shares were offered in connection with this sale and issuance ofthese shares, in the form of an additional investment right with an exerciseprice of $1.00 per share and warrants for 4,411,765 shares at exercise pricescurrently ranging from $1.1428 to $1.2820 per share. The additional investmentright expired on November 2, 2004. The warrants are exercisable during theperiod January 30, 2005 through January 30, 2006.

All shares issued in connection with the abovedescribed sales of common stock were drawn-down off of a shelf registrationstatement which was filed by Wave on April 15, 2004 and declared effectiveby the Securities and Exchange Commission (the “SEC”) on May 10, 2004.

On November 18, 2003,Wave issued 3,725,263 shares of its Class A Common Stock at a price of$1.90 per share and granted warrants to purchase 931,309 shares of Class ACommon Stock at a an exercise price of $2.62 per share in a private placementto a group of accredited investors for proceeds of approximately $6,562,000,net of issuance costs of approximately $516,000. The warrants have a three (3) yearterm.  In addition, in connection withthe transaction, Wave incurred commissions of $218,000 for the fair marketvalue of warrants granted to placement agents to purchase approximately 161,595shares of Wave’s Class A Common Stock. The warrants granted to theplacement agents are also exercisable at a price of $2.62 per share and have athree- (3) year life as well. If exercised in full, the warrants grantedin connection with this financing will generate up to an additional $2,864,000,at the exercise price. Pursuant to a registration 

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rightsagreement entered into with the accredited investors for the sales of theseshares, Wave agreed to file a registration statement with the Securities andExchange Commission covering the resale of the Class A Common Shares soldand those underlying the warrants, and bear all expenses therefrom. Wave filedthe registration statement on Form S-3 covering the resale of theshares on January 20, 2004. On February 12, 2004 the registrationstatement was declared effective by the Commission.

*Series HPreferred Stock and Warrant*

On April 30, 2003, Wave completed a privateplacement of 548.5 shares of its Series H Convertible Preferred Stock (the“Series H Stock”) and warrants to purchase Wave’s Class A CommonStock for an aggregate purchase price of $5,485,000, with a group ofinstitutional and accredited investors. Wave realized aggregate proceeds of$4,780,540 net of commissions and other cash fees of $704,460, in connection withthe transaction.  In addition, Waveincurred commissions of $315,969 for the fair market value of warrants grantedto placement agents to purchase 322,270 shares of Wave’s Class A CommonStock at $0.01. All of the warrants granted to the placement agents have beenexercised as of December 31, 2003 for proceeds of $3,223. As of December 31,2003 all 548.5 shares of Series H Stock were converted at a conversionprice of $0.76 into 7,217,105 shares of Class A Common Stock.

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

*Exercise ofWarrants to Purchase Class A Common Stock*

On August 1, 2005, Wave received gross proceedsof $2,260,000 less placement agent fees of $90,400 for net proceeds of$2,169,600, for theissuance of 2,000,000 shares of Class A Common Stock upon partial exerciseof a warrant that was granted to an accredited investor as part of a securitiespurchase agreement with the accredited investor, dated July 30, 2004. Thewarrants were exercised at a price of $1.13 per share.

During 2003, 2,632,311shares of Class A Common Stock were issued in connection with the exerciseof Series H Warrants for net proceeds of $2,490,167. Series HWarrants to acquire 65,789 shares of Class A Common Stock remainoutstanding as of March 1, 2004.

*Exercise ofemployee stock options*

On November 1, 2005 Wave issued 238,666 shares ofClass A Common Stock to Wave and Wavexpress employees for $0.68 per share,pursuant to the Wave 2004 Employee Stock Purchase Plan. Wave received proceedsof $162,293, from the sale of these shares.

On June 1, 2005 Wave issued 253,475 shares of Class ACommon Stock to Wave and Wavexpress employees for $0.765 per share, pursuant tothe Wave 2004 Employee Stock Purchase Plan. Wave received proceeds of $191,754,from the sale of these shares.

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During 2004, employees exercised stock optionsresulting in the issuance of 35,309 shares of Wave Class A Common Stockfor proceeds of $34,295, at an average price of $0.97 per share.

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

*Proceeds fromrepayment of officer notes receivable*

Prior to the enactment of the Sarbanes-Oxley Act of2002, Wave had made loans to certain of its officers. Some of the loans wereextended beyond their original terms by one year. These loans and theextensions thereon, were granted to the officers, prior to the enactment of theSarbanes-Oxley Act of 2002, to allow them to satisfy certain personal financialobligations that would otherwise have required them to liquidate some of theirholdings of Wave shares. The loans were granted as a means to mitigate apotential unfavorable impact to Wave’s share price as a result of the officersselling large blocks of shares. All loans to officers were paid in full as of December 31,2003. Wave received proceeds of $1,135,320 from the repayment of these loans.

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

*Summary analysis ofhistorical cash flows and future outlook*

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

*LiquidityRequirements and Future Sources of Capital*

Wave estimates that its total expenditures to fundoperations for the year ending December 31, 2006 will be approximately$19,100,000, including research and development, acquisition of capital assets,sales and marketing, general corporate expenses and overhead.

Expected sources ofcapital include the following:

·       cashon hand of $2,006,022 as of December 31, 2005

·       grossmargin contribution from sales and licensing of products

·       additionalfinancings including the sale on February 16, 2006 of 8,348,598 shares ofcommon stock for gross proceeds of $4,466,500 for which we receivedapproximately $4,247,000 after subtracting underwriter and other fees. Inaddition, in connection with this sale of common stock we granted warrants topurchase up to 1,550,868 shares of common stock at an exercise price of $0.72per share which will yield approximately $1,072,000 in net proceeds ifexercised in full.

Given Wave’s capital requirements for the year ending December 31,2006 as indicated above, and our cash balance as of December 31, 2005,Wave will be required to raise additional capital to continue to fund itsoperations.

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Weplan to obtain additional funding from further sales of newly issued shares ofClass A Common Stock including the sale of Class A CommonStock under the remaining availability of two $25,000,000 shelf registrationstatements; one that we filed on April 15, 2004 that the Securities andExchange Commission declared effective on May 10, 2004 and one that wefiled on December 16, 2005 that the Securities and Exchange Commissiondeclared effective on January 13, 2006. Since that time, we have completedseveral sales of Class A Common Stock under these registration statements,which are discussed above.

The remaining availabilityunder this Shelf Registration, after subtracting the $26,685,530 in grossproceeds from the financings referred to above (including the February 16,2006 financing), is approximately $23,314,470, of which $1,991,625 is reservedfor the unexercised warrants which expire June 3, 2006 throughAugust 15, 2006.

*Revenue outlook*

During 2003, Wave beganlicensing its EMBASSY Trust Suite software through bundling arrangementswith OEMs with whom it signed contracts with during the year. In addition, Wavereceived revenues from software development and other services. Total cashreceived from all revenue sources in 2005 was approximately $961,000 versusapproximately $335,000 for 2004.

In November of 2005,Wave signed a new OEM distribution agreement with Dell that permits Dell todistribute Wave software on certain Dell TPM-equipped business PCs. Wave willbe paid a per unit royalty fee for each Dell product shipment which includesWave’s software.   In addition, pursuantto this same agreement, it is expected that Dell will offer an upgrade packageof Wave’s software that purchasers of certain models of TPM-equipped computersmay buy. Wave will be paid a license fee, for each copy of the upgrade packagethat is purchased. We are working with Dell to market our products, in aneffort to drive volume of purchases of the upgrade package. However, we have noreliable basis to predict how many upgrade packages will be purchased, and whatthe resultant revenue to Wave might be from this program. There are no minimumroyalty or shipped quantity requirements.

In January of 2006,Wave signed a distribution agreement with Gateway, that permits Gateway to distributeWave software on Gateway TPM-equipped models. Wave will be paid a per unitroyalty fee for each Gateway shipment which includes Wave’s software. Inaddition, pursuant to this same agreement, it is expected that Gateway willoffer an upgrade package of Wave’s software that purchasers of certain modelsof TPM-equipped computers may buy. Wave will be paid a license fee, for eachcopy of the upgrade package that is purchased. We are working with Gateway tomarket our products, in an effort to drive volume of purchases of the upgradepackage. However, we have no reliable basis to predict how many upgradepackages will be purchased, and what the resultant revenue to Wave might befrom this program. There are no minimum royalty or shipped quantity requirements.

Wave also continues towork with all of its partners and customers to introduce and promote itsexisting software products and new software products which are underdevelopment, in an effort to expand the market for TPM-based secure computingand thereby increase its market share and revenues. However, it should be notedthat because of the early stage of Wave’s market and other factors, a highlevel of uncertainty exists with respect to the ability to forecast futurerevenues.   Although there has been asubstantial increase in the volume of shipments of TPM chips, TPM hardwaresecurity that meets the TCG industry standard, which our business model dependsupon, is still a new, developing category within the computer security market,the ultimate size of this market and the timeframe for its development areunknown and difficult to predict.

We believe the recentdistribution agreements that were signed with Dell and Gateway should generateroyalty revenue beginning in the second quarter of 2006. The aggregate amountof royalty revenue from these arrangements for 2006 may be material. We expectto begin to receive any payments of these additional royalties in the thirdquarter of 2006.

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Wave will also continue topursue hardware sales and licensing of its proprietary EMBASSY Trust System,primarily in government-related security markets.

As stated previously,Wavexpress currently has two active contracts with customers for its broadbandmedia distribution services. Under these contracts Wavexpress sharessubscription and/or advertising revenue generated by the client’s website inaddition to bandwidth fees. Given that this is a new type of service, it isdifficult to predict the subscription levels and therefore the revenue thatwill be generated from these contracts. In addition, Wavexpress has a number ofadditional customer prospects with whom it may close business in 2006; however,it is also difficult to predict the number of contracts that it will enter intoduring the year.

*Known Trends andUncertainties affecting future cash flows*

Because Wave does not havesufficient cash to fund operations for the year ending December 31, 2006;and given the uncertainties described above with respect to Wave’s revenueoutlook for 2006, Wave has been and will continue to be actively engaged infinancing activities in order to generate additional funding to cover itsoperating costs for the year ending December 31, 2006. These activitiesinclude the filing of a second $25,000,000 S-3 shelf registration withthe SEC on December 16, 2005 which was declared effective on January 13,2006; and the closing of an initial round of financing under this shelfregistration on February 16, 2006, upon which we received approximately$4,247,000 in net proceeds, for the sale of 8,348,598 shares of common stock at$0.535 per share. It is likely that we will be required to sell additionalshares of common stock, preferred stock, obtain debt financing or engage in acombination of these financing alternatives, to raise additional capital tocontinue to fund our operations for the year ending December 31, 2006.  The availability and amount of any suchfinancings are unknown at this time. Wave may also be required to reduceexpenses which may significantly impede its ability to meet its sales,marketing and development objectives. Given the available cash currently onhand and our expenditure forecast for the year ending December 31, 2006,we estimate that we will need to generate at least $12,000,000, over and abovethe $4,247,000 that we received from the February 16, 2006 sale of commonstock, from a combination of revenue growth and additional financingactivities, in order to continue as a going concern for the year ending December 31,2006.

*Other uncertainties that may impact the futurebusiness outlook*

Uncertainty exists withrespect to the legal matters that are currently pending including the formalSEC investigation and the class action securities and derivative shareholderlawsuits that have been commenced against Wave. There is uncertainty as to theamount of legal costs that Wave may incur in addressing these matters. Inaddition, the extent of any impact due to negative publicity or perceivednegative publicity is unknown.

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

Furthermore, theachievement of sufficient revenue is dependent upon continued significantexpenditures, which will likely be required for research and development andsales and marketing to increase market awareness, beyond December 31,2006, to increase market awareness. Therefore, if Wave is not able to begin togenerate significant revenues by December 31, 2006 to cover its operatingcosts, it will need to generate capital from other sources, and the likelihoodis Wave will need to raise funds through either issuing additional commonstock, preferred stock and/or debt to fund its operations beyond December 31,2006.

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*Commitments*

Wavehas no significant long-term contractual obligations other than with respect tooperating leases for its facilities, which are listed below: 

| ** **                    | ** ** | **Within one  year** | ** ** | **Years two and  three** | ** ** | **Years four and  five** | ** ** | **Total** | ** ** |
|-------------------------------|------------|---------------------------|------------|------------------------------------|------------|------------------------------------|------------|-----------|------------|
| Operating leases  commitments |       |                      | $          | 766,430                            |       |                               |       | $         | 751,855    |   |   |   | $ | 171,623 |   |   | $ | 1,689,908 |   |
|                               |            |                           |            |                                    |            |                                    |            |           |            |  |  |  |  |  |  |  |  |  |  |

 

*Net Operating andCapital Loss Carryforwards*

As of December 31,2005, Wave had available net operating and capital loss carryforwards forFederal income tax purposes of approximately $252 million, which expirebeginning in 2006 through 2025. Because of the “change in ownership” provisionsof the Tax Reform Act of 1986, our net operating and capital loss carryforwardsmay be subject to an annual limitation on the utilization of thesecarryforwards against taxable income in future periods if a cumulative changein ownership of more than 50 percent of Wave occurs within any three-yearperiod. We have made no determination concerning whether there have beensuch  cumulative changes in ownership orthe impact on the utilization of the loss carryforwards if such changes haveoccurred. However, in considering Section 382 of the Internal RevenueCode, we believe that it is likely that such a change in ownership occurredprior to or following the completion of our initial public offering inSeptember 1994 and, potentially, in periods following. As a result, all ofthe utilization of our net operating losses is likely to be subject to annuallimitations.

*Going ConcernOpinion*

Wave’s consolidated financial statements as ofDecember 31, 2005 have been prepared under the assumption that we willcontinue as a going concern. Wave’s independent registered public accountingfirm, KPMG LLP, have issued a report dated March 9, 2006, that includes anexplanatory paragraph referring to our significant operating losses andsubstantial doubt of our ability to continue as a going concern. (See Note 2 toWave’s consolidated financial statements.)

**Recent Accounting Pronouncements**

In December 2004, the Financial Accounting StandardsBoard (“FASB”) issued its final standard on accounting for share-basedpayments, Statement of Financial Accounting Standard No. 123(R)—Share-BasedPayment (“SFAS 123(R)”). SFAS 123(R) requires companies to expense the fairvalue of employee stock options and similar equity compensation, also known asshare-based payment (“SBP”) awards. The statement applies to all outstandingand unvested SBP awards as of a company’s adoption date. The Securities andExchange Commission delayed implementation of SFAS 123(R) to fiscal yearsbeginning after June 15, 2005. Therefore, we implemented SFAS 123(R) effectiveJanuary 1, 2006 using the modified prospective method, which requires therecognition of expense for SBP awards over their remaining vesting period. Theportion of these SBPs’ fair value attributable to awards that vested prior tothe adoption of SFAS 123(R) is never recognized under this method.  We estimate that the impact of the adoptionof SFAS 123(R), to Wave for the year ending December 31, 2006, will be anexpense of approximately $1.4 million, or $0.01 to $0.02 per share. However,our assessment of the estimated compensation charges is dependent uponassumptions regarding a number of complex and subjective variables. Thesevariables include, but are not limited to, the volatility of our stock price,interest rates, the level and type of SBPs that Wave awards and employee stockoption exercise behaviors. As such, our actual share-based compensation expensemay differ from this estimated amount.

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**Item 7A.   Quantitative and Qualitative Disclosureabout Market Risk**

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

**Item8.   Financial Statements and Supplementary Data**

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

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

Not Applicable.

**Item 9A.   Controls and Procedures**

*Evaluation of disclosure controls and procedures*

Our CEO and CFO haveevaluated the effectiveness of our disclosure controls and procedures as of December 31,2005.  Based on their evaluation, our CEOand CFO have concluded, as of the date of such evaluation, that our disclosurecontrols and procedures are effective.

*Management’s Report on Internal Control Over FinancialReporting*

Wave’s management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as defined in Rule 13a-15(f) promulgatedunder the Exchange Act. Wave’s internal control system was designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. Wave’s management assessed theeffectiveness of its internal control over financial reporting as of December 31,2005. In making its assessment, Wave’s management used the criteria set forthby the Committee of Sponsoring Organizations of the Treadway Commission in “InternalControl Integrated Framework”. Based on this assessment, Wave’s managementconcluded that, as of December 31, 2005, its internal control overfinancial reporting is effective based on those criteria.  Wave’s Independent Registered PublicAccounting Firm, KPMG LLP, has issued an attestation report on management’sassessment of Wave’s internal control over financial reporting, which isincluded following this report.

Dated: March 9, 2006

WAVE SYSTEMS CORP.
| By:    |   | /s/ STEVEN K.  SPRAGUE |   | By:                                      |   | /s/ GERARD T.  FEENEY |   |
|--------|--------|------------------------|--------|------------------------------------------|--------|-----------------------|--------|
|   |   | Name:                  |   | Steven K. Sprague                        |   |                  |   | Name: |   | Gerard T. Feeney |   |
|   |   | Title:                 |   | *President  and Chief Executive Officer* |   |                  |   | Title: |   | *Senior Vice President of Finance and  Administration, Chief Financial Officer* |   |

 

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*Report of IndependentRegistered Public Accounting Firm*

The Board of Directors and StockholdersWave Systems Corp.:

We have audited management’s assessment, included inthe accompanying ***Management’s Report on Internal Control OverFinancial Reporting,*****thatWave Systems Corp. and subsidiaries (a development stage corporation)maintained effective internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO)*.*The Company’s managementis responsible for maintaining effective internal control over financialreporting and for its assessment of the effectiveness of internal control overfinancial reporting. Our responsibility is to express an opinion on management’sassessment and an opinion on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

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

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

In our opinion, management’s assessment that WaveSystems Corp. maintained effective internal control over financial reporting asof December 31, 2005, is fairly stated, in all material respects, based oncriteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission*.*Also, in our opinion, Wave Systems Corp.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued bythe Committee of SponsoringOrganizations of the Treadway Commission .

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We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Wave Systems Corp. andsubsidiaries (a development stage corporation) as of December 31, 2005 and2004, and the related consolidated statements of operations, stockholders’equity (deficiency) and comprehensive income (loss), and cash flows for each ofthe years in the three-year period ended December 31, 2005, and the periodfrom February 12, 1988 (date of inception) to December 31, 2005 andour report dated March 9, 2006 expressed an unqualified opinion on thoseconsolidated financial statements. Our report dated March 9, 2006 containsan explanatory paragraph that states that the Company has suffered recurringlosses from operations and has an accumulated deficit that raises substantialdoubt about its ability to continue as a going concern. The consolidatedfinancial statements do not include any adjustments that might result from theoutcome of that uncertainty.

KPMG LLP

Boston, MassachusettsMarch 9, 2006

*Changes in internalcontrols*

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

**Item 9B.**OtherInformation**

Not Applicable.

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**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant

Information concerning Wave’s directors and executiveofficers will appear in Wave’s Proxy Statement for the 2006 Annual Meeting ofStockholders, to be filed pursuant to Regulation 14A on or before April 30,2006, under the caption “Election of Directors.” Such information isincorporated herein by reference.

Information concerning compliance with Section 16(a) ofthe Securities Exchange Act will appear in Wave’s Proxy Statement for the 2006Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A on orbefore April 30, 2006, under the caption “Compliance with Section 16(a) ofthe Exchange Act.” Such information is incorporated herein by reference.

Information concerning Wave’s Audit Committee willappear in Wave’s Proxy Statement for the 2006 Annual Meeting of Stockholders,to be filed pursuant to Regulation 14A on or before April 30, 2006, underthe caption “The Board of Directors and its Committees” Such information isincorporated herein by reference.

Wave’s Board of Directors has adopted a code of ethicsthat applies to its Chief Executive Officer and Chief Financial Officer (the “Codeof Ethics”). The Code of Ethics has been posted on Wave’s Internet website atwww.wave.com. Wave intends to satisfy the disclosure requirements under Item 10of Form 8-K regarding an amendment to, or waiver from, a provisionof the Code of Ethics that relates to a substantive amendment or materialdeparture from a provision of the Code of Ethics by posting such information onits internet website at www.wave.com.

**Item 11.**                 ExecutiveCompensation

Information regardingexecutive compensation will appear in Wave’s Proxy Statement for the 2006Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A on orbefore April 30, 2006, under the caption “Executive Compensation.”  Such information is incorporated herein byreference.

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

Information regardingsecurity ownership of certain beneficial owners and management and relatedstockholder matters will appear in Wave’s Proxy Statement for the 2006 AnnualMeeting of Stockholders, to be filed pursuant to Regulation 14A on or before April 30,2006, under the caption “Security Ownership of Certain Beneficial Owners andManagement.”  Such information isincorporated herein by reference.

**Item 13.**                 CertainRelationships and Related Transactions

Information regardingcertain relationships and related transactions will appear in Wave’s ProxyStatement for the 2006 Annual Meeting of Stockholders, to be filed pursuant toRegulation 14A on or before April 30, 2006, under the caption “CertainRelationships and Related Transactions.” Such information is incorporated herein by reference.

**Item 14.**                 PrincipalAccountant’s Fees

Information regarding Wave’s principle accountant’sfees will appear in Wave’s Proxy Statement for the 2006 Annual Meeting ofStockholders, to be filed pursuant to Regulation 14A on or before April 30,2006, under the caption “Certain Relationships and Related Transactions.”  Such information is incorporated herein byreference.

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**PART IV**

**Item 15.**                 Exhibits,Financial Statement Schedules, and Reports on Form 8-K

(a) (1)            FinancialStatements:

|                                                                                                                                                                                                                                                                         | ** ** | **Page(s)** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|
| Index to Consolidated  Financial Statements                                                                                                                                                                                                                             |       | F-1         |
| Report of Independent  Registered Public Accounting Firm                                                                                                                                                                                                                |       | F-2         |
| Consolidated Balance  Sheets as of December 31, 2005 and 2004                                                                                                                                                                                                      |       | F-3         |
| Consolidated  Statements of Operations for each of the years ended December 31,  2005, 2004 and 2003 and for the period from February 12, 1988  (inception) through December 31, 2005                                                               |       | F-4         |
| Consolidated  Statements of Stockholders’ Equity (Deficiency) and Other Comprehensive  Income (Loss) for each of the years ended December 31, 2005, 2004  and 2003 and for the period from February 12, 1988 (inception) through  December 31, 2005 |       | F-5         |
| Consolidated  Statements of Cash Flows for each of the years ended December 31,  2005, 2004 and 2003 and for the period from February 12, 1988  (inception) through December 31, 2005                                                               |       | F-12        |
| Notes to Consolidated  Financial Statements                                                                                                                                                                                                                             |       | F-14        |

 

(a) (2)            FinancialStatement Schedules:

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

(a) (3)   Exhibits:

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

48

----

 

| 4.6*         | — | Certificate of Designation of Series F  Convertible Preferred Stock of Wave as filed with the Delaware Secretary of  State on October 9, 1997 (incorporated by reference to Exhibit 3.1  of Wave’s Current Report on Form 8-K, filed on October 15,  1997, File No. 0-24752) |
|--------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.7*         | — | Certificate of Designation of Series G  Convertible Preferred Stock of Wave as filed with the Delaware Secretary of  State on March 5, 1998 (incorporated by reference to Exhibit 3.1 of  Wave’s Current Report on Form 8-K, filed on March 19, 1998,  File No. 0-24752)     |
| 4.8*         | — | Certificate of Designation of Series H  Convertible Preferred Stock of Wave as filed with the Delaware Secretary of  State on April 30, 2003 (incorporated by reference to Exhibit 4.1  of Wave’s Current Report on Form 8-K, filed on May 5, 2003,  File No. 0-24752)       |
| †10.1*  | — | Wave Systems Corp. 2004 Employee Stock Purchase Plan  (incorporated by reference to Exhibit 4.1 of Wave’s Form S-8 Registration  Statement, filed on May 24,2005)                                                                                                                           |
| 10.2*        | — | Securities Purchase Agreement dated as of  December 5, 2005 among Purchasers and Wave (includes form of warrant)  (incorporated by reference to Exhibit 10.1 of Wave’s Current Report on  Form 8-K, filed on December 7, 2005, File # 0-24752)                                         |
| 10.3*        | — | Securities Purchase Agreement dated as of  August 5, 2005 among Purchasers and Wave (includes form of warrant)  (incorporated by reference to Exhibit 10.1 of Wave’s Current Report on  Form 8-K, filed on August 8, 2005, File # 0-24752)                                             |
| 10.4*        | — | Securities Purchase Agreement dated as of  March 15, 2005 among Purchasers and Wave (includes form of warrant)  (incorporated by reference to Exhibit 10.1 of Wave’s Current Report on  Form 8-K, filed on March  17, 2005, File # 0-24752)                                            |
| †10.5*  | — | Wave’s Amended and Restated 1994 Stock Option Plan  (incorporated by reference to Wave’s Notice of Annual Meeting of Stockholders  on Schedule 14A filed on April 29, 2004,)                                                                                                                     |
| †10.6*  | — | Wave Non-Employee Directors Stock Option Plan  (incorporated by reference to Wave’s Notice of Annual Meeting of Stockholders  on Schedule 14A filed on April 29, 2004)                                                                                                                                |
| †10.7*  | — | Wave 1996 Performance Stock Option Plan  (incorporated by reference to Exhibit 10.12 of Wave’s Annual Report on  Form 10-K, filed on April 1, 2002, File #0-24752)                                                                                                                          |
| 10.8         | — | Reserved                                                                                                                                                                                                                                                                                                        |
| †10.9*  | — | Employment Contract, dated  June 8, 1998, between Gerard T. Feeney and Wave (incorporated by  reference to Exhibit 10.18 of Wave’s Annual Report on Form 10-K,  filed on April 1, 1999, File No. 0-24752).                                                                        |
| †10.10* | — | Employment Contract, dated  November 10, 1998, between Steven Sprague and Wave (incorporated  by reference to Exhibit 10.19 of Wave’s Annual Report on Form 10-K,  filed on April 1, 1999, File No. 0-24752).                                                                     |
| 10.11*       | — | Asset Purchase Agreement dated August 13, 2000,  by and among Wave and Indigo Networks, LLC (incorporated by reference to  Exhibit 99.1 of Wave’s Current Report on Form 8-K, filed on  September 15, 2000, File #0-24752)                                                        |
| 10.12*       | — | Office Building Lease dated October 20, 2002  between Stevens Creek Investors, LLC and Wave (incorporated by reference to  Exhibit 10.13 of Wave’s Annual Report on Form 10-K, filed on  March 31, 2003, File #0-24752)                                                                |
| 10.13*       | — | Form of Asset Purchase Agreement dated  October 4, 2001, by and between Wave and SignOnLine (incorporated by  reference to Exhibit 10.15 of Wave’s Annual Report on Form 10-K,  filed on April 1, 2002, File #0-24752)                                                            |
| 10.14*       | — | First Amendment to Asset Purchase Agreement dated  October 4, 2001, by and between Wave and SignOnLine (incorporated by  reference to Exhibit 10.16 of Wave’s Annual Report on Form 10-K,  filed on April 1, 2002, File #0-24752)                                                      |

49

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| 10.15* | — | Termination  Agreement and Mutual Release between Wave Systems Corp. and SSP  Solutions, Inc. date September 30, 2002 (Incorporated herein by  referenced to Exhibit 10.1 of Wave’s Quarterly Report on Form 10-Q  for the quarter ended September 30, 2002, filed on November 14,  2002, File #0-24752) |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.16* | — | Subordinated Convertible Promissory Note between  Wave Systems Corp. and SSP Solutions, Inc. dated September 30,  2002 (Incorporated herein by referenced to Exhibit 10.2 of Wave’s  Quarterly Report on Form 10-Q for the quarter ended  September 30, 2002, filed on November 14, 2002, File #0-24752) |
| 10.17* | — | Share Purchase Agreement between Redwave plc,  GlobalWave Group plc and Wave Systems Corp. dated June 19, 2002 (Incorporated herein by  referenced to Exhibit 10.3 of Wave’s Quarterly Report on Form 10-Q/A  for the quarter ended September 30, 2002, filed on March 19, 2003, File #0-24752)               |
| 10.18* | — | GlobalWave Group plc Notice of Extraordinary General  Meeting dated June 20, 2002 (Incorporated herein by referenced to Exhibit 10.4  of Wave’s Quarterly Report on Form 10-Q/A for the quarter ended  September 30, 2002, filed on March 19, 2003, File #0-24752)                                            |
| 10.19* | — | Joint Venture Agreement dated October 15, 1999  between Wave, Wavexpress and Sarnoff. (incorporated by reference to  Exhibit 10.20 of Wave’s Annual Report on Form 10-K/A, filed  on June 27, 2003, File #0-24752)                                                                                                 |
| 10.20* | — | Stockholder Agreement dated October 15, 1999  between Wave, Wavexpress and Sarnoff. (incorporated by reference to  Exhibit 10.21 of Wave’s Annual Report on Form 10-K/A, filed  on June 27, 2003, File #0-24752)                                                                                                   |
| 10.21* | — | Securities Purchase Agreement dated as of  July 30, 2004 among Purchasers and Wave (incorporated by reference to  Exhibit 10.1 of Wave’s Current Report on Form 8-K, filed on  August 3, 2004, File #0-24752)                                                                                                      |
| 10.22* | — | Additional Investment Right to Purchase 3,529,412  Shares of Common Stock of Wave Systems Corp. (incorporated by reference to  Exhibit 10.2 of Wave’s Current Report on Form 8-K, filed on  August 3, 2004, File #0-24752)                                                                                              |
| 10.23* | — | Series A Common Stock Purchase Warrant to  Purchase 3,529,412 Shares of Class A Common Stock of Wave Systems Corp.  (incorporated by reference to Exhibit 10.3 of Wave’s Current Report on  Form 8-K, filed on August 3, 2004, File #0-24752)                                                                 |
| 10.24* | — | Series B Common Stock Purchase Warrant to  Purchase 882,353 Shares of Class A Common Stock of Wave Systems Corp.  (incorporated by reference to Exhibit 10.4 of Wave’s Current Report on  Form 8-K, filed on August 3, 2004, File # 0-24752)                                                                  |
| 10.25* | — | Placement Agency Agreement between Corpfin Inc. and  Wave (incorporated by reference to Exhibit 10.5 of Wave’s Current Report  on Form 8-K, filed on August 3, 2004, File # 0-24752)                                                                                                                                    |
| 10.26* | — | Securities Purchase Agreement dated as of  December 16, 2004 among Purchasers and Wave (incorporated by reference  to Exhibit 10.1 of Wave’s Current Report on Form 8-K, filed  on December 17, 2004, File # 0-24752)                                                                                              |
| 10.27* | — | Form of Addendum No. 1 to Authorized Distributor  Agreement between Wave and Envoy Data Inc. dated December 14, 2004                                                                                                                                                                                                         |
| 10.28* | — | Securities Purchase Agreement dated as of  February 15, 2006 among Purchasers and Wave (incorporated by reference  to Exhibit 10.1 of Wave’s Current Report on Form 8-K, filed  on February 21, 2006, File # 0-24752)                                                                                              |
| 21.1*  | — | Subsidiaries of Registrant (incorporated by  reference to Exhibit 10.12 of Wave’s Annual Report on Form 10-K,  filed on April 1, 2002, File #0-24752)                                                                                                                                                                   |
| 23.1   | — | Consent of Independent Registered Public Accounting  Firm—KPMG LLP                                                                                                                                                                                                                                                                     |
| 31.1   | — | Section 302 Certification by Steven K. Sprague,  President and Chief Executive Officer                                                                                                                                                                                                                                                 |

50

----

 

| 31.2   | — | Section 302 Certification by Gerard T. Feeney,  Chief Financial Officer                                                                                                                                                                                                                                                         |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 32.1   | — | Section 906 Certification                                                                                                                                                                                                                                                                                                       |
| 99.1*  | — | Form of Series H Convertible Preferred  Stock Purchase Agreement, dated as of April 30, 2003 (the “First  Purchase Agreement”), by and among Wave and the purchasers of the  Series H Convertible Preferred Stock (Incorporated by reference to  Wave’s Form 8-K filed on May 5, 2003). |
| 99.2*  | — | Form of Series H Convertible Preferred  Stock Purchase Agreement, dated as of April 30, 2003 (the “Second  Purchase Agreement”), by and between Wave and an individual purchaser  (Incorporated by reference to Wave’s Form 8-K filed on May 5,  2003).                                      |
| 99.3*  | — | Form of Registration Rights Agreement by and  among Wave and the purchasers of the Series H Convertible Preferred  Stock, dated as of April 30, 2003 (Incorporated by reference to Wave’s  Form 8-K filed on May 5, 2003).                                                                             |
| 99.4*  | — | Form of Warrant issued by Wave pursuant to the  First Purchase Agreement to each of the purchasers of the Series H  Convertible Preferred Stock, dated as of April 30, 2003 (Incorporated by  reference to Wave’s Form 8-K filed on May 5, 2003).                                                      |
| 99.5*  | — | Form of Warrant issued by Wave pursuant to the  Second Purchase Agreement to the individual purchaser, dated as of  April 30, 2003 (Incorporated by reference to Wave’s Form 8-K  filed on May 5, 2003).                                                                                                    |
| 99.6*  | — | Form of Warrant issued by Wave to the placement  agent and sub-placement agents, dated as of April 30, 2003 (Incorporated  by reference to Wave’s Form S-3 filed on May 14, 2003  (Registration No. 333-99469)).                                                                                       |
| 99.7*  | — | Letter Amendment to First Purchase Agreement and  Second Purchase Agreement effected on August 11, 2003 (Incorporated by  reference to Wave’s Form 8-K filed on August 12, 2003).                                                                                                                                |
| 99.8*  | — | Form of Letter Agreement to the Series H  Convertible Preferred Stock Purchase Agreements dated September 4, 2003,  effected on September 15, 2003 (Incorporated by reference to Wave’s  Form 8-K filed on September 16, 2003).                                                                   |
| 99.9*  | — | Form of Waiver to the Series H Preferred  Stock Purchase Agreements dated September 4, 2003, effected on  September 15, 2003 (Incorporated by reference to Wave’s Form 8-K  filed on September 16, 2003).                                                                                         |
| 99.10* | — | Securities Purchase Agreement, dated as of  November 18, 2003, by and among Wave and purchasers of the Class A  common stock. (Incorporated by reference to Wave’s registration statement  filed on Form S-3/A filed on February 12, 2004. (Registration  No. 333-112017.))                            |
| 99.11* | — | Form of Warrant issued by Wave to each of the  purchasers of the Class A Common Stock and the placement agents, dated  as of November 18, 2003 with the schedule of holders attached thereto.  (Incorporated by reference to Wave’s Form 8-K/A filed on  February 13, 2004).                           |
| 99.12* | — | Registration Rights Agreement by and among Wave and  the purchasers of the Class A Common Stock, dated as of  November 18, 2003. (Incorporated by reference to Wave’s Form 8-K/A  filed on February 13, 2004).                                                                                              |
| 99.13* | — | Demand Note, dated March 26, 2001 between  Gerard T. Feeney and Wave (incorporated by reference to Exhibit 99.1 of  Wave’s Annual Report on Form 10-K, filed on April 1, 2002,  File #0-24752)                                                                                                              |
| 99.14* | — | Demand Note, dated February 27, 2001 between  Peter J. Sprague and Wave (incorporated by reference to Exhibit 99.2 of  Wave’s Annual Report on Form 10-K, filed on April 1, 2002,  File #0-24752)                                                                                                           |

51

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| 99.15* | — | Demand Note, dated July 25, 2001 between Peter  J. Sprague and Wave (incorporated by reference to Exhibit 99.3 of Wave’s  Annual Report on Form 10-K, filed on April 1, 2002, File #0-24752)                              |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 99.16* | — | Demand Note, dated September 5, 2001 between  Peter J. Sprague and Wave (incorporated by reference to Exhibit 99.4 of  Wave’s Annual Report on Form 10-K, filed on April 1, 2002,  File #0-24752)                         |
| 99.17* | — | Allonge to Demand Promissory Note, dated  March 26, 2002 between Gerard T. Feeney and Wave (incorporated by  reference to Exhibit 99.6 of Wave’s Annual Report on Form 10-K/A,  filed on June 30, 2003, File #0-24752)    |
| 99.18* | — | Allonge to Demand Promissory Note, dated  February 27, 2002 between Peter J. Sprague and Wave (incorporated by  reference to Exhibit 99.7 of Wave’s Annual Report on Form 10-K/A,  filed on June 30, 2003, File #0-24752) |
| 99.19* | — | Allonge to Demand Promissory Note, dated  July 25, 2002 between Peter J. Sprague and Wave (incorporated by  reference to Exhibit 99.8 of Wave’s Annual Report on Form 10-K/A,  filed on June 30, 2003, File #0-24752)     |

----

*                    Incorporatedherein by reference

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

†                    Managementcontract or compensatory plan.

(b)          Reports on Form 8-K

52

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**SIGNATURES**

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

Dated:  March 16, 2006

|        | WAVE SYSTEMS CORP. |
|--------|--------------------|
|   | By:                | /s/  STEVEN K SPRAGUE |
|   |               | Name: Steven K.  Sprague |
|   |               | Title: President and Chief  Executive Officer |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
|                                    | **Signature**                                                                                                                                                            | ** **           | ** ** | **Title** | ** ** | ** ** | **Date** | ** ** |
|------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------|------------|-----------|------------|------------|----------|------------|
| /s/  STEVEN K. SPRAGUE             | President, Chief  Executive Officer                                                                                                                                      | March 16,  2006 |
| Steven K. Sprague                  |  and Director                                                                                                                                                       |                 |
| /s/  JOHN E. BAGALAY, JR.     | Chairman                                                                                                                                                                 | March 16,  2006 |
| John E.  Bagalay, Jr.         |                                                                                                                                                                     |                 |
| /s/  GEORGE GILDER                 | Director                                                                                                                                                                 | March 16,  2006 |
| George Gilder                      |                                                                                                                                                                     |                 |
| /s/  JOHN E. MCCONNAUGHY, JR. | Director                                                                                                                                                                 | March 16,  2006 |
| John E.  McConnaughy, Jr.     |                                                                                                                                                                     |                 |
| /s/  NOLAN BUSHNELL                | Director                                                                                                                                                                 | March 16,  2006 |
| Nolan Bushnell                     |                                                                                                                                                                     |                 |
| /s/  GERARD T. FEENEY              | Senior Vice  President, Finance and Administration, Chief Financial  Officer and Secretary (Principal  Financial Officer and Duly Authorized  Officer of the Registrant) | March 16,  2006 |
| Gerard T. Feeney                   |                                                                                                                                                                     |

 

53

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**Indexto Consolidated Financial Statements**

|                                                                                                                                                                                                                                                                  | ** ** | **Page(s)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                                                                                                                                                         |       |        | F-2        |   |   |
| Consolidated  Balance Sheets as of December 31, 2005 and 2004                                                                                                                                                                                               |       |        | F-3        |   |   |
| Consolidated Statements of Operations for each of the  years ended December 31, 2005, 2004 and 2003 and for the period from  February 12, 1988 (inception) through December 31, 2005                                                              |       |        | F-4        |   |   |
| Consolidated Statements of Stockholders’ Equity  (Deficiency) and Comprehensive Income (Loss) for each of the years ended  December 31, 2005, 2004 and 2003 and for the period from  February 12, 1988 (inception) through December 31, 2005 |       |        | F-5        |   |   |
| Consolidated Statements of Cash Flows for each of the  years ended December 31, 2005, 2004 and 2003 and for the period from  February 12, 1988 (inception) through December 31, 2005                                                              |       |        | F-12       |   |   |
| Notes  to Consolidated Financial Statements                                                                                                                                                                                                                      |       |        | F-14       |   |   |

 

F-1

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

The Board of Directors and StockholdersWave Systems Corp.:

We have audited the accompanying consolidated balancesheets of Wave Systems Corp. and subsidiaries (a development stage corporation)as of December 31, 2005 and 2004, and the related consolidated statementsof operations, stockholders’ equity (deficiency) and comprehensive income(loss), and cash flows for each of the years in the three-year period ended December 31,2005 and for the period from February 12, 1988 (date of inception) to December 31,2005. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Wave Systems Corp. and subsidiaries as of December 31, 2005and 2004, and the results of their operations and their cash flows for each ofthe years in the three-year period ended December 31, 2005 and for theperiod from February 12, 1988 (date of inception) to December 31,2005 in conformity with accounting principles generally accepted in the UnitedStates of America.

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

Wealso have audited, in accordance with standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of Wave SystemsCorp. internal control over financial reporting as of December 31, 2005,based on criteria established in Internal Control-Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission (COSO) andour report dated March 9, 2006, expressed an unqualified opinion onmanagement’s assessment of, and the effective operation of internal controlover financial reporting.

| Boston, Massachusetts | /s/ KPMG LLP |
|-----------------------|--------------|
| March 9,  2006   |         |

 

F-2

----

**WAVESYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Balance SheetsDecember 31, 2005 and 2004**

| ** **                                                                                                                                             | ** ** | **2005**     | ** ** | **2004**     | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|------------|--------------|------------|
| **Assets**                                                                                                                                             |       |         |       |         |       |
| Current assets:                                                                                                                                        |       |         |       |         |       |
| Cash and cash equivalents                                                                                                                              |       | $            | 2,006,022  |         | $          | 5,805,912 |   |
| Marketable securities                                                                                                                                  |       | —       |       | 721,880      |       |
| Accounts Receivable                                                                                                                                    |       | 334,659      |       | 98,641       |       |
| Prepaid expenses                                                                                                                                       |       | 139,686      |       | 173,916      |       |
| Total current assets                                                                                                                                   |       | 2,480,367    |       | 6,800,349    |       |
| Property and equipment, net                                                                                                                            |       | 754,153      |       | 1,435,053    |       |
| Other assets                                                                                                                                           |       | 195,245      |       | 219,180      |       |
| Total Assets                                                                                                                                           |       | 3,429,765    |       | 8,454,582    |       |
| **Liabilities  and Stockholders’ Equity (Deficiency)**                                                                                            |       |         |       |         |       |
| Current  liabilities:                                                                                                                                  |       |         |       |         |       |
| Accounts payable and accrued expenses                                                                                                                  |       | 3,089,150    |       | 2,900,064    |       |
| Deferred revenue                                                                                                                                       |       | 503,630      |       | 351,190      |       |
| Total current liabilities                                                                                                                              |       | 3,592,780    |       | 3,251,254    |       |
| Liability  for warrants containing cash settlement provisions                                                                                          |       | 2,794        |       | 493,128      |       |
| Total  liabilities                                                                                                                                     |       | 3,595,574    |       | 3,744,382    |       |
| Stockholders’ Equity (Deficiency):                                                                                                                |       |         |       |         |       |
| Common Stock,  $.01 par value. Authorized 150,000,000 shares as Class A; 93,341,754  shares issued and outstanding in 2005 and 76,177,617 in 2004 |       | 933,418      |       | 761,776      |       |
| Common Stock,  $.01 par value. Authorized 13,000,000 shares as Class B; 175,725 shares  issued and outstanding in 2005 and 205,725 in 2004        |       | 1,757        |       | 2,057        |       |
| Capital in excess  of par value                                                                                                                        |       | 283,645,842  |       | 270,664,189  |       |
| Deficit accumulated during the development stage                                                                                                       |       | (284,746,826 | )          | (267,184,364 | )          |
| Accumulated other  comprehensive income—unrealized gain on marketable securities                                                                  |       | —       |       | 466,542      |       |
| Total Stockholders’ Equity (Deficiency)                                                                                                           |       | (165,809     | )          | 4,710,200    |       |
| Total Liabilities and  Stockholders’ Equity (Deficiency)                                                                                          |       | $            | 3,429,765  |         | $          | 8,454,582 |   |

 

See accompanying notes to consolidated financial statements.

F-3

----

**WAVESYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Statements of Operations**

**Years ended December 31,2005, 2004, 2003 and theperiod from February 12, 1988 (date of inception)through December 31, 2005**

| ** **                                                                                    | ** ** | **2005**    | ** ** | **2004**    | ** ** | **2003**    | ** **  | **Period from  February 12, 1988  through  December 31,  2005** | ** **   |
|-----------------------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|-------------|-------------------------------------------------------------------------------------|--------------|
| Net Revenues:                                                                                 |       |        |       |        |       |        |        |                                                                                |         |   |   |
| Licensing                                                                                     |       | $           | 974,058    |        | $          | 183,318     |        | $                                                                                   | 120,670      |   |   | $ | 1,783,945 |   |   |
| Services                                                                                      |       | 44,406      |       | 18,833      |       | 65,343      |        |                                                                                | 869,879      |   |   |
| Hardware products                                                                             |       | —      |       | 7,160       |       | 3,350       |        |                                                                                | 496,624      |   |   |
| Total Net Revenues                                                                            |       | 1,018,464   |       | 209,311     |       | 189,363     |        |                                                                                | 3,150,448    |   |   |
| Cost of sales:                                                                                |       |        |       |        |       |        |        |                                                                                |         |   |   |
| Licensing                                                                                     |       | 682,179     |       | 133,468     |       | 39,361      |        |                                                                                | 990,645      |   |   |
| Services                                                                                      |       | 44,674      |       | 13,589      |       | 12,948      |        |                                                                                | 430,917      |   |   |
| Hardware Products                                                                             |       | —      |       | 4,647       |       | 2,870       |        |                                                                                | 288,572      |   |   |
| Total Cost of Sales                                                                           |       | 726,853     |       | 151,704     |       | 55,179      |        |                                                                                | 1,710,134    |   |   |
| Gross profit                                                                                  |       | 291,611     |       | 57,607      |       | 134,184     |        |                                                                                | 1,440,314    |   |   |
| Operating expenses:                                                                           |       |        |       |        |       |        |        |                                                                                |         |   |   |
| Selling, general and  administrative                                                          |       | 11,560,039  |       | 12,255,427  |       | 12,698,682  |        |                                                                                | 164,174,108  |   |   |
| Research and development                                                                      |       | 6,937,618   |       | 6,852,754   |       | 7,384,708   |        |                                                                                | 105,137,768  |   |   |
| Inventory provision                                                                           |       | —      |       | —      |       | 1,114,442   |        |                                                                                | 1,114,442    |   |   |
| Amortization of goodwill                                                                      |       | —      |       | —      |       | —      |        |                                                                                | 2,294,176    |   |   |
| Write-off of intangibles  and other impaired assets                                           |       | —      |       | 301,366     |       | —      |        |                                                                                | 3,634,314    |   |   |
| Restructuring costs and  other special charges                                                |       | —      |       | —      |       | —      |        |                                                                                | 726,280      |   |   |
| Write-off of goodwill                                                                         |       | —      |       | —      |       | —      |        |                                                                                | 3,054,456    |   |   |
| In-process research and  development expense                                                  |       | —      |       | —      |       | —      |        |                                                                                | 2,176,000    |   |   |
| Acquisition costs                                                                             |       | —      |       | —      |       | —      |        |                                                                                | 1,494,000    |   |   |
| Aladdin license expense                                                                       |       | —      |       | —      |       | —      |        |                                                                                | 3,889,000    |   |   |
|                                                                                          |       | 18,497,657  |       | 19,409,547  |       | 21,197,832  |        |                                                                                | 287,694,544  |   |   |
| Other income (expense):                                                                       |       |        |       |        |       |        |        |                                                                                |         |   |   |
| Interest income                                                                               |       | 70,779      |       | 24,931      |       | 74,822      |        |                                                                                | 10,361,833   |   |   |
| Interest expense                                                                              |       | —      |       | —      |       | —      |        |                                                                                | (1,695,461   | ) |   |
| Equity in net losses of  GlobalWave                                                           |       | —      |       | —      |       | —      |        |                                                                                | (5,738,650   | ) |   |
| Loss on other than  temporary decline in marketable equity securities                         |       | —      |       | —      |       | —      |        |                                                                                | (13,249,781  | ) |   |
| Gain on sale of  marketable securities                                                        |       | 80,971      |       | 4,330,248   |       | 234,759     |        |                                                                                | 5,188,435    |   |   |
| Gain on termination of  development contract                                                  |       | —      |       | —      |       | —      |        |                                                                                | 1,818,000    |   |   |
| Liquidated damages                                                                            |       | —      |       | —      |       | (155,716    | )           |                                                                                | (155,716     | ) |   |
| Unrealized gain on  decrease in value of warrant liability                                    |       | 490,334     |       | 498,723     |       | 263,097     |        |                                                                                | 1,252,154    |   |   |
| Recovery of officer note  receivable                                                          |       | —      |       | —      |       | 999,518     |        |                                                                                | —       |   |   |
| License fee                                                                                   |       | —      |       | —      |       | —      |        |                                                                                | 5,000,000    |   |   |
| License warrant cost                                                                          |       | —      |       | —      |       | —      |        |                                                                                | (1,100,000   | ) |   |
| Other income (expense)                                                                        |       | 1,500       |       | —      |       | 52,370      |        |                                                                                | (173,410     | ) |   |
|                                                                                          |       | 643,584     |       | 4,853,902   |       | 1,468,850   |        |                                                                                | 1,507,404    |   |   |
| Net loss                                                                                      |       | (17,562,462 | )          | (14,498,038 | )          | (19,594,798 | )           |                                                                                | (284,746,826 | ) |   |
| Accrued dividends on  preferred Stock (including $5,485,000 of accretion of discount in 2003) |       | —      |       | —      |       | 5,697,518   |        |                                                                                | 10,048,115   |   |   |
| Net loss to common  stockholders                                                              |       | (17,562,462 | )          | (14,498,038 | )          | $           | (25,292,316 | )                                                                                   |         | $ | (294,794,941 | ) |   |
| Loss per common  share—basic and diluted                                                 |       | $           | (0.21      | )           | $          | (0.21       | )           | $                                                                                   | (0.45        | ) |   | $ | (10.05 | ) |   |
| Weighted average number  of common shares  outstanding during the period                      |       | 83,178,663  |       | 69,040,661  |       | 55,887,384  |        |                                                                                | 29,323,741   |   |   |

 

See accompanying notes to consolidated financial statements.

F-4

----

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

 

See accompanying notes to consolidated financial statements.

F-5

 

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Statements of Stockholders’ Equity (Deficiency) And ComprehensiveIncome (Loss)—(Continued)**

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

 

See accompanying notes to consolidated financial statements.

F-6

 

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Statements of Stockholders’ Equity (Deficiency) And ComprehensiveIncome (Loss)—(Continued)**

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

 

See accompanying notes to consolidated financial statements.

F-7

 

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Statements of Stockholders’ Equity (Deficiency) And ComprehensiveIncome (Loss)—(Continued)**

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

 

See accompanying notes to consolidated financial statements.

F-8

 

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Statements of Stockholders’ Equity (Deficiency)  And Comprehensive Income (Loss)—(Continued)**

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

 

See accompanying notes to consolidated financial statements.

F-9

 

----

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

 

F-10

 

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Statements of Stockholders’ Equity (Deficiency)  And Comprehensive Income (Loss)—(Continued)**

| ** **                                                                                                         | ** ** | **Class A  Common Stock** | ** ** | **Class B  Common Stock** | ** ** | **Capital in Excess** | ** ** | **Deficit  Accumulated  During the  Development** | ** ** | **Accumulated  Other Comprehensive** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** **                                                                                                         | ** ** | **Shares**                          | ** ** | **Amount**                          | ** ** | **Shares**                      | ** ** | **Amount**                                             | ** ** | **of Par Value**                | ** ** | **Stage**  | ** ** | **Income** | ** ** | **Total** | ** ** |
| Balance at December 31, 2003                                                                                  |       | 67,128,106                          |       | $                                   | 671,281    |                            | 205,725    |                                                   |       | $                                         | 2,057      |       |       |   | $ | 262,387,155 |   |   | $ | (252,686,326 | ) |   | $ | 3,640,469 |   |   | $ | 14,014,636 |   |
| Net loss                                                                                                           |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | —     |   |   | (14,498,038 | ) |   | — |   |   | (14,498,038 | ) |
| Unrealized Gain on  Marketable Securities:                                                                         |       |                                |       |                                |       |                            |       |                                                   |       |                                      |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding gains during the period                                                                         |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | —     |   |   | — |   |   | 1,156,321 |   |   | — |   |
| Less: reclassification adjustment for gain included  in net income                                                 |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | —     |   |   | — |   |   | (4,330,248 | ) |   | (3,173,927 | ) |
| Comprehensive loss                                                                                                 |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | —     |   |   | — |   |   | — |   |   | (17,671,965 | ) |
| Issuance of Class A Common Stock at $0.85 per  share, net of issuance costs of $222,101                       |       | 3,529,412                           |       | 35,294                              |       | —                          |       |                                                   | —     |                                      |       |       | 2,742,603  |   |   | — |   |   | — |   |   | 2,777,897 |   |
| Issuance of Class A Common Stock at $1.05 per  share, net of issuance costs of $284,300                       |       | 5,484,790                           |       | 54,848                              |       | —                          |       |                                                   | —     |                                      |       |       | 5,419,880  |   |   | — |   |   | — |   |   | 5,474,728 |   |
| Issuance of Class A Common Stock upon exercise  of employee stock options                                     |       | 35,309                              |       | 353                                 |       | —                          |       |                                                   | —     |                                      |       |       | 33,942     |   |   | — |   |   | — |   |   | 34,295 |   |
| Issuance of warrants to purchase Class A Common  Stock for services                                           |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | 80,609     |   |   | — |   |   | — |   |   | 80,609 |   |
| Balance as of December 31, 2004                                                                               |       | 76,177,617                          |       | $                                   | 761,776    |                            | 205,725    |                                                   |       | $                                         | 2,057      |       |       |   | $ | 270,664,189 |   |   | $ | (267,184,364 | ) |   | $ | 466,542 |   |   | $ | 4,710,200 |   |
| Net loss                                                                                                           |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | —     |   |   | (17,562,462 | ) |   | — |   |   | (17,562,462 | ) |
| Unrealized loss on  marketable securities:                                                                         |       |                                |       |                                |       |                            |       |                                                   |       |                                      |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding losses during the period                                                                        |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | —     |   |   | — |   |   | (385,571 | ) |   |   |   |
| Less: reclassification adjustment for gain included  in net income                                                 |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | —     |   |   | — |   |   | (80,971 | ) |   | (466,542 | ) |
| Comprehensive loss                                                                                                 |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | —     |   |   | — |   |   | — |   |   | (18,029,004 | ) |
| Issuance of Class A Common Stock at $0.88 per  share, less issuance cost of $208,041                     |       | 4,659,090                           |       | 46,591                              |       | —                          |       |                                                   | —     |                                      |       |       | 3,845,368  |   |   | — |   |   | — |   |   | 3,891,959 |   |
| Issuance of Class A Common Stock at $0.90 per  share, less issuance cost of $210,975                     |       | 4,000,000                           |       | 40,000                              |       | —                          |       |                                                   | —     |                                      |       |       | 3,349,205  |   |   | — |   |   | — |   |   | 3,389,205 |   |
| Issuance of Class A Common Stock at $0.585 per  share, less issuance cost of $159,110                         |       | 5,982,906                           |       | 59,829                              |       | —                          |       |                                                   | —     |                                      |       |       | 3,281,061  |   |   | — |   |   | — |   |   | 3,340,890 |   |
| Warrants Exercised at $1.13 per share, less issuance  cost of $90,400                                              |       | 2,000,000                           |       | 20,000                              |       | —                          |       |                                                   | —     |                                      |       |       | 2,149,600  |   |   | — |   |   | — |   |   | 2,169,600 |   |
| Shares of Class A Common Stock Issued pursuant  to the Wave Employee Stock Purchase Plan at $0.7565 per share |       | 253,475                             |       | 2,535                               |       | —                          |       |                                                   | —     |                                      |       |       | 189,219    |   |   | — |   |   | — |   |   | 191,754 |   |
| Shares of Class A Common Stock Issued pursuant  to the Wave Employee Stock Purchase Plan at $0.68 per share   |       | 238,666                             |       | 2,387                               |       | —                          |       |                                                   | —     |                                      |       |       | 159,906    |   |   | — |   |   | — |   |   | 162,293 |   |
| Compensation cost for stock options granted to  consultant                                                         |       | —                              |       | —                              |       | —                          |       |                                                   | —     |                                      |       |       | 7,294      |   |   | — |   |   | — |   |   | 7,294 |   |
| Exchange of Class B Common Stock for  Class A Common Stock                                               |       | 30,000                              |       | 300                                 |       | (30,000                         | )          |                                                   | (300       | )                                         |       |       | —     |   |   | — |   |   | — |   |   | — |   |
| Balance as of  December 31, 2005                                                                              |       | 93,341,754                          |       | $                                   | 933,418    |                            | 175,725    |                                                   |       | $                                         | 1,757      |       |       |   | $ | 283,645,842 |   |   | $ | (284,746,826 | ) |   | $ | — |   |   | $ | (165,809 | ) |

 

See accompanying notes to consolidated financial statements.

F-11

 

----

**WAVESYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Statements of Cash Flows**

**Yearsended December 31, 2005, 2004, 2003, and the PeriodFrom February 12, 1988 (Date of Inception) through December 31, 2005**

| ** **                                                                            | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | **Period from**              | ** **   |
|---------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-----------------------------------|--------------|
| ** **                                                                            | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | **February 12, 1988**   | ** **   |
| ** **                                                                            | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | **(date of inception)** | ** **   |
| ** **                                                                            | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | **through**                       | ** **   |
| ** **                                                                            | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | **December 31,**             | ** **   |
| ** **                                                                            | ** ** | **2005**    | ** **  | **2004**    | ** ** | **2003**    | ** ** | **2005**                          | ** **   |
| Cash flows from operating activities:                                                 |       |        |        |        |       |        |       |                              |         |   |   |
| Net loss                                                                              |       | $           | (17,562,462 | )           | $          | (14,498,038 | )          | $                                 | (19,594,798  | ) |   | $ | (284,746,826 | ) |   |
| Adjustments to reconcile  net loss to net cash used in operating activities:     |       |        |        |        |       |        |       |                              |         |   |   |
| Write-off of  goodwill                                                                |       | —      |        | —      |       | —      |       |                              | 3,054,456    |   |   |
| Goodwill  amortization                                                                |       | —      |        | —      |       | —      |       |                              | 2,294,176    |   |   |
| Depreciation and  amortization                                                        |       | 841,729     |        | 854,629     |       | 1,241,035   |       |                              | 12,569,524   |   |   |
| Reserve for note  from affiliate                                                      |       | —      |        | —      |       | —      |       |                              | 1,672,934    |   |   |
| Recovery of  officer note receivable                                                  |       | —      |        | —      |       | (999,518    | )          |                              | —       |   |   |
| Accretion of  assured incremental yield on convertible debt                           |       | —      |        | —      |       | —      |       |                              | 119,000      |   |   |
| Common stock  issued in connection with license agreement                             |       | —      |        | —      |       | —      |       |                              | 1,124,960    |   |   |
| Realized gain on  marketable securities                                               |       | (80,971     | )           | (4,330,248  | )          | (234,759    | )          |                              | (5,188,435   | ) |   |
| Net losses  realized on GlobalWave investment                                         |       | —      |        | —      |       | —      |       |                              | 5,738,650    |   |   |
| Common stock  issued for services rendered and additional interest on borrowings |       | —      |        | —      |       | —      |       |                              | 3,600,199    |   |   |
| Warrants issued as  compensation for services                                         |       | —      |        | 80,609      |       | 43,176      |       |                              | 3,018,880    |   |   |
| Issuance of  warrants to Aladdin                                                      |       | —      |        | —      |       | —      |       |                              | 2,939,000    |   |   |
| Accrued interest  on note payable                                                     |       | —      |        | —      |       | —      |       |                              | 121,219      |   |   |
| In-process  research and development                                                  |       | —      |        | —      |       | —      |       |                              | 2,176,000    |   |   |
| Write-off of  impaired assets                                                         |       | —      |        | 301,366     |       | —      |       |                              | 3,634,314    |   |   |
| Loss on other than  temporary decline in marketable equity Securities            |       | —      |        | —      |       | —      |       |                              | 13,249,781   |   |   |
| Gain on  termination of development contract with SSP                                 |       | —      |        | —      |       | —      |       |                              | (1,818,000   | ) |   |
| Gain on decrease  in value of warrant liability                                       |       | (490,334    | )           | (498,723    | )          | (263,097    | )          |                              | (1,252,154   | ) |   |
| Preferred stock  issued for services rendered                                         |       | —      |        | —      |       | —      |       |                              | 265,600      |   |   |
| Compensation  associated with issuance of stock options                               |       | 7,294       |        | —      |       | 146,389     |       |                              | 2,026,557    |   |   |
| Amortization of  deferred compensation                                                |       | —      |        | —      |       | —      |       |                              | 398,660      |   |   |
| Amortization of  discount on notes payable                                            |       | —      |        | —      |       | —      |       |                              | 166,253      |   |   |
| Common stock  issued by principal stockholder for services                            |       | —      |        | —      |       | —      |       |                              | 565,250      |   |   |
| Changes in assets and liabilities:                                                    |       |        |        |        |       |        |       |                              |         |   |   |
| Increase in  deferred revenue                                                         |       | 152,440     |        | 276,968     |       | 74,222      |       |                              | 503,630      |   |   |
| Decrease in  accrued interest on note receivable                                      |       | —      |        | —      |       | 142,540     |       |                              | —       |   |   |
| Decrease in  inventories                                                              |       | —      |        | —      |       | 1,112,818   |       |                              | —       |   |   |
| (Increase)  decrease in accounts receivable and prepaid expenses                      |       | (201,788    | )           | (67,085     | )          | 368,844     |       |                              | (444,027     | ) |   |
| (Increase)  decrease in other assets                                                  |       | 23,935      |        | 93,570      |       | 50,688      |       |                              | (210,160     | ) |   |
| Increase  (decrease) in accounts payable and accrued expenses                         |       | 189,086     |        | 63,540      |       | (567,853    | )          |                              | 3,478,252    |   |   |
| Decrease in  amounts due to charities                                                 |       | —      |        | (243,197    | )          | (19,959     | )          |                              | —       |   |   |
| Decrease in cash  collected on behalf of charities                                    |       | —      |        | 211,717     |       | 23,836      |       |                              | —       |   |   |
| Net cash used in  operating activities                                                |       | (17,121,071 | )           | (17,754,892 | )          | (18,476,436 | )          |                              | (230,942,307 | ) |   |
|                                                                                  |       |        |        |        |       | (Continued) |       |
|                                                                                       |            |             |             |             |            |             |            |                                   |              |  |  |  |  |  |  |

 

See accompanying notes toconsolidated financial statements.

F-12

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Statements of Cash Flows (Continued)**

**Yearsended December 31, 2005 2004 2003 and the PeriodFrom February 12, 1988 (Date of Inception) through December 31, 2005**

| ** **                                                        | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **Period from**February 12, 1988  (date of  inception)  throughDecember 31,  2005 | ** **  |
|-------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|----------------------------------------------------------------------------------------------------------------------|-------------|
| Cash flows from  investing activities:                            |       |       |       |       |       |       |       |                                                                                                                 |        |   |   |
| Acquisition of property and equipment                             |       | (160,829   | )          | (304,172   | )          | (985,146   | )          |                                                                                                                 | (12,893,623 | ) |   |
| Investment in GlobalWave joint venture                            |       | —     |       | —     |       | —     |       |                                                                                                                 | (5,701,250  | ) |   |
| Cash received in GlobalWave acquisition                           |       | —     |       | —     |       | —     |       |                                                                                                                 | 1,380,464   |   |   |
| Purchase of intangible assets                                     |       | —     |       | —     |       | —     |       |                                                                                                                 | (2,500,000  | ) |   |
| Short-term loans to affiliate                                     |       | —     |       | —     |       | —     |       |                                                                                                                 | (1,672,934  | ) |   |
| Organizational costs                                              |       | —     |       | —     |       | —     |       |                                                                                                                 | (14,966     | ) |   |
| Proceeds provided by sale of marketable equity  securities        |       | 336,309    |       | 6,759,751  |       | 430,934    |       |                                                                                                                 | 9,689,447   |   |   |
| Exercise of warrant to acquire marketable equity  securities      |       | —     |       | —     |       | —     |       |                                                                                                                 | (1,620,000  | ) |   |
| Net cash provided by (used in) investing activities               |       | 175,480    |       | 6,455,579  |       | (554,212   | )          |                                                                                                                 | (13,332,862 | ) |   |
| Cash flows from  financing activities:                            |       |       |       |       |       |       |       |                                                                                                                 |        |   |   |
| Net proceeds from issuance of common stock                        |       | 13,145,701 |       | 8,286,920  |       | 11,924,486 |       |                                                                                                                 | 225,968,325 |   |   |
| Net proceeds from issuance of preferred stock and  warrants  |       | —     |       | —     |       | 4,780,540  |       |                                                                                                                 | 16,988,573  |   |   |
| Payment on (issuance of) note receivable from  stockholder   |       | —     |       | —     |       | 1,135,320  |       |                                                                                                                 | —      |   |   |
| Payment of dividends on preferred stock                           |       | —     |       | —     |       | (212,517   | )          |                                                                                                                 | (212,517    | ) |   |
| Proceeds from notes payable and warrants to stockholders          |       | —     |       | —     |       | —     |       |                                                                                                                 | 4,083,972   |   |   |
| Repayments of notes payable to stockholders                       |       | —     |       | —     |       | —     |       |                                                                                                                 | (1,069,972  | ) |   |
| Proceeds from notes payable and warrants                          |       | —     |       | —     |       | —     |       |                                                                                                                 | 1,284,250   |   |   |
| Repayments of note payable                                        |       | —     |       | —     |       | —     |       |                                                                                                                 | (255,000    | ) |   |
| Redemption of Preferred Stock                                     |       | —     |       | —     |       | —     |       |                                                                                                                 | (506,440    | ) |   |
| Net cash provided by financing activities                         |       | 13,145,701 |       | 8,286,920  |       | 17,627,829 |       |                                                                                                                 | 246,281,191 |   |   |
| Net increase (decrease) in cash and cash equivalents              |       | (3,799,890 | )          | (3,012,393 | )          | (1,402,819 | )          |                                                                                                                 | 2,006,022   |   |   |
| Cash and cash equivalents at beginning of year                    |       | 5,805,912  |       | 8,818,305  |       | 10,221,124 |       |                                                                                                                 | —      |   |   |
| Cash and cash  equivalents at end of year                         |       | $          | 2,006,022  |       | $          | 5,805,912  |       | $                                                                                                                    | 8,818,305   |   |   | $ | 2,006,022 |   |   |
|                                                                   |            |            |            |            |            |            |            |                                                                                                                      |             |  |  |  |  |  |  |

 

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

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

Wave recorded accretion of discount of $5,485,000 forthe year ended December 31, 2003 in connection with the issuance of 548.5shares of its Series H Convertible Preferred Stock (see note 8).

During 2003 Wave issued7,217,105 shares of Class A Common Stock in connection with the conversionof 548.5 shares of Series H Convertible Preferred Stock, with an aggregateface value of $5,485,000 at a conversion price of $0.76 per share of Class ACommon Stock.

See accompanying notes to consolidated financialstatements.

F-13

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**(1) Business of theCompany**

Wave Systems Corp., adevelopment stage company, develops, produces and markets products forhardware-based digital security including security applications and servicesthat are complementary to and compliant with the specifications of the TrustedComputing Group, www.trustedcomputinggroup.org (“TCG”). Specificationsdeveloped by the TCG are designed to address a broad range of current andevolving digital security issues facing the industry. These issues include thefollowing: identity protection, data security, digital signatures, electronictransaction integrity, platform trustworthiness, network security, andregulatory compliance. Wave’s products are designed to solve many of thesedigital security issues.

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

**(2) Liquidity**

The accompanyingconsolidated financial statements have been prepared assuming that Wave willcontinue as a going concern. Wave has incurred substantial operating lossessince its inception, and as of December 31, 2005, has an accumulateddeficit of $284,746,826. We also expect Wave will incur an operating loss forthe calendar year of 2006. As of December 31, 2005, we had negativeworking capital of $1,112,413.

Wave has begun marketintroduction of its security and broadband media distribution software productsand has signed initial distribution contracts for these applications. However,due to the early stage nature of this market, it is unlikely that Wave willgenerate sufficient revenue to cover all of its cash flow needs to fund itsoperating requirements for the year ending December 31, 2006.

Because Wave does not havesufficient cash to fund operations for the year ending December 31, 2006;and given the uncertainties described above with respect to Wave’s revenueoutlook for 2006, Wave has been and will continue to be actively engaged infinancing activities in order to generate additional funding to cover itsoperating costs for the year ending December 31, 2006. These activitiesinclude the filing of a second $25,000,000 S-3 shelf registration withthe SEC on December 16, 2005 which was declared effective onJanuary 31, 2006; and the sale of 8,348,598 shares of common stock at$0.535 per share for gross proceeds of $4,466,500 in an initial round offinancing under this shelf registration on February 15, 2006, upon whichwe received approximately $4,247,000 in net proceeds. We also granted warrantsas part of the February 15 financing that will allow the purchasers toacquire an additional 1,550,868 shares of Wave common stock  for $0.72 per share. If exercised, thewarrants will generate additional gross proceeds of $1,116,625. These warrantsexpire on August 15, 2006.

It is likely that we willbe required to sell additional shares of common stock, preferred stock, obtaindebt financing or engage in a combination of these financing alternatives,utilizing this shelf registration, to raise additional capital to continue tofund our operations for the year ending December 31, 2006.  The remaining availability under this shelfregistration statement for future financings, after subtracting the proceedsfrom the February 15, 2006 financing referred to above is $20,533,500,including $1,116,625 reserved for the warrants.

Also, previously, onApril 15, 2004 Wave filed a $25,000,000 registration statement with theSEC, under which Wave has drawn down a total of $22,219,030 in gross proceeds,through various sales of common stock and issuances of Warrants (See footnote 8).Accordingly, there remains approximately $2,781,000 in gross proceeds availableunder the April 15, 2004 shelf of which $875,000 is reserved for warrantsto purchase 1,093,750 shares with an exercise price of $0.80, that expireMay 5, 2006.

F-14

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**(2) Liquidity (Continued)**

The combined availabilityunder the two registration statements for future financings totals $23,314,500,of which $1,991,625 is reserved for outstanding warrants. The availability andamount of any such financings are unknown at this time. In addition, presentlythe outstanding warrants are “out-of-the-money” and will expire unexercised ifthe market price of Wave’s common stock does not exceed the exercise prices ofthe warrants before their expiration date.

Considering our currentcash balance, including the additional capital raised on February 15, 2006that is referred to above, we project that we have enough liquid assets tocontinue operating into May 2006. We estimate we will need a minimum ofapproximately $12,000,000 of additional cash from a combination of revenuegrowth and additional financings, to fund operating expenses and capitalexpenditures for the year ending December 31, 2006.

If Wave is not successfulin raising the needed capital referred to above, or is not successful inexecuting its business plan, we could be forced to reduce expenses which may significantlyimpede our ability to meet our sales, marketing and development objectives,cease operations or merge with another company. No assurance can be provided that any of these initiatives will besuccessful.  Due to our current cashposition, our capital needs over the next year and beyond, the fact that wehave not at this time secured enough financing to fund our operations throughDecember 31, 2006 and beyond, and the uncertainty as to whether we willachieve our sales forecast for our products and services, substantial doubtexists with respect to our ability to continue as a going concern.

**(3) SignificantAccounting Policies**

*(a) Basis ofConsolidation*

The consolidated financialstatements include the financial statements of Wave, Wave SystemsHoldings, Inc., a wholly owned subsidiary and Wavexpress, Inc. amajority-owned joint venture. All significant intercompany accounts andtransactions have been eliminated in consolidation.

*(b) Use ofEstimates*

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

*(c) Method ofAccounting for Joint Ventures*

Wave accounts for itsinvestments in joint ventures using the equity method of accounting when itsownership interest in the joint venture is less than fifty percent and it isdetermined that Wave has the ability to exercise significant influence over thejoint venture’s operating and financial policies. The financial statements ofjoint ventures in which Wave owns greater than a fifty percent interest areconsolidated with Wave’s financial statements (see note 12).

*(d) Cash and CashEquivalents*

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

*(e) MarketableSecurities*

Investments, which consist solely of equitysecurities, are accounted for under Statement of Financial Accounting Standards(SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity 

F-15

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

Securities”issued by the Financial Accounting Standards Board (FASB). Pursuant to the provisionsof SFAS No.115, investments are classified as “trading”, “available-for sale”or “held to maturity”. “Trading” securities are bought and held principally forthe purpose of selling them in the near term and are recorded at fair value.Fair value is based upon quoted market prices. Unrealized gains and losses ontrading securities are included in the determination of net earnings.“Available-for-sale” securities are being held for an unspecified period oftime and may be used for liquidity or other corporate purposes and are recordedat fair value. Unrealized gains and losses on available-for-sale securities arereported as a separate component of comprehensive income (loss) instockholders’ equity. Unrealized losses that are determined to be other thantemporary are recognized as charges against earnings. Factors considered whendetermining if an other than temporary decline has occurred include: whether adecline in market value is related to specific concerns of the issuer of thesecurities as opposed to general market conditions, the length of time of thedecline in market price, the financial condition and near-term prospects of theissuer and other factors that may indicate that the value of the securitieswill not recover. “Held to maturity” securities are debt securities that areintended to be held to maturity and are recorded at amortized cost. As ofDecember 31, 2004, all of Wave’s marketable equity securities wereclassified as available-for-sale. Wave held no marketable securities as of December 31,2005.

*(f) Property andEquipment*

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

*(g) Income Taxes*

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

*(h) Stock OptionPlan*

Statement of FinancialAccounting Standards  No. 123, “*Accounting**for Stock-basedCompensation,*” as amended by SFAS No. 148 “*Accountingfor Stock-Based Compensation Transition and Disclosure—an amendment to FASBStatement No. 123,*” (“SFAS No. 123”) allows companies torecognize expense for the fair value of stock-based awards or to continue toapply the provisions of Accounting Principles Board (“APB”) Opinion No. 25“Accounting for Stock Issued to Employees,” and disclose the effects of SFASNo. 123 as if the fair-value-based method defined in SFAS No. 123 hadbeen applied. Under APB Opinion No. 25, compensation expense is recognizedonly if on the measurement date the fair value of the underlying stock exceedsthe exercise price. Wave has elected to apply the intrinsic value methodpursuant to APB Opinion No. 25 and provide the pro forma disclosureprovisions of SFAS No. 123 and SFAS No. 148.

F-16

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

The following tablepresents Wave’s pro forma net loss and loss per share as if the company hadaccounted for stock options under SFAS No. 123 for the years endedDecember 31:

| ** **                                               | ** ** | **2005**    | ** **  | **2004**    | ** ** | **2003**    | ** ** |
|----------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|
| Net loss—as  reported                               |       | $           | (17,562,462 | )           | $          | (14,498,038 | )          | $ | (19,594,798 | ) |
| Pro-forma  compensation cost using the fair-value method |       | (2,103,508  | )           | (2,840,103  | )          | (3,023,011  | )          |
| Net loss—pro  forma                                 |       | (19,665,970 | )           | (17,338,141 | )          | (22,617,809 | )          |
| Net loss to  Common stockholders—as reported        |       | (17,562,462 | )           | (14,498,038 | )          | (25,292,316 | )          |
| Net loss to  Common shareholders—pro forma          |       | (19,665,970 | )           | (17,338,141 | )          | (28,315,327 | )          |
| Loss per Common  share—as reported                  |       | (0.21       | )           | (0.21       | )          | (0.45       | )          |
| Loss per Common share—pro  forma                    |       | $           | (0.24       | )           | $          | (0.25       | )          | $ | (0.51 | ) |

 

Theper share weighted-average fair value of stock options granted under all plansfor the years ended December 2005, 2004 and 2003 pursuant to SFASNo. 123 were $0.81, $1.03 and $1.20, respectively. The expense that wouldhave been recognized pursuant to SFAS No. 123 and the weighted averagefair values per share referred to herein were arrived at using the BlackScholes option-pricing model with the following weighted-average assumptions:

| ** **             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected Life  (Years) |       | 5        |       | 5        |       | 5        |       |
| Interest Rate          |       | 4.23     | %          | 3.675    | %          | 3.25     | %          |
| Volatility             |       | 104      | %          | 120      | %          | 125      | %          |
| Dividend Yield         |       | 0        | %          | 0        | %          | 0        | %          |

 

Wave applies APB OpinionNo. 25 in accounting for its Plans. Compensation expense has beenrecognized in the financial statements for Stock options granted to employeesat exercise prices below fair market value of approximately $7,294 in 2005, $0in 2004 and $146,000 in 2003.

*(i) Researchand Development and Software Development Costs*

Research and developmentcosts are expensed as incurred. Software development costs are accounted forpursuant to Statement of Financial Accounting Standards No. 86 “Accountingfor the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed” whichrequires software development costs for products that have achieved commercialmarketability to be capitalized subsequent to the establishment of a product’stechnological feasibility and prior to general release of the product. Wave didnot capitalize any software development costs for 2005. Wave capitalizedsoftware development costs of approximately $73,000 and $712,000 during the years endedDecember 31, 2004 and 2003, respectively. Amortization of capitalizedsoftware costs for the years ended December 31, 2005, 2004 and 2003 was$621,419, $538,781 and $232,373, respectively

*(j) Loss Per Share*

Basic net loss per common share has been calculatedbased upon the weighted average number of shares of common stock outstandingduring the period. Diluted net loss per share is also computed using theweighted average number of common shares and excludes dilutive potential commonshares outstanding, as their effect is anti-dilutive. Dilutive potential commonshares consist primarily of employee stock options, stock warrants andconvertible preferred stock. Diluted net loss per share is equal to basic netloss per share and is therefore not presented separately in the financialstatements. The weighted average number of potential common shares that wouldhave been included in diluted loss per share had their effect not beenanti-dilutive for the each of the years ended December 31, 2005, 2004 and2003 were approximately 200,000 shares, 261,000 shares and 4,200,000 shares,respectively. Employee stock options and other stock warrants to purchase aweighted average of approximately 16,544,000, 14,260,000  and 

F-17

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

8,784,000shares were outstanding for the years ended December 31, 2005, 2004 and2003 respectively, but would not have been included in the computation ofdiluted loss per share because their exercise price was greater than theaverage share price of Wave’s common shares and, therefore, their effect wouldhave been anti-dilutive.

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

Wavereviews the valuation of long-lived assets, including property and equipmentand capitalized software, under the provisions of SFAS No. 144, *“Accounting for the Impairment or Disposal of Long-Lived Assets”*(“SFAS No. 144”) and SFAS No.86, *“Accounting for the Costsof Computer Software to Be Sold, Leased, or Otherwise Marketed”*(“SFAS No. 86”), respectively. Wave is required to assess therecoverability of long-lived assets and capitalized software development costsbasis whenever events and circumstances indicate that the carrying value maynot be recoverable. Factors we consider important that could trigger animpairment review include the following:

·       significantunderperformance relative to expected historical or projected future operatingresults;

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

·       significantnegative industry or economic trends; and

·       significantdecline in our stock price for a sustained period.

In accordance with SFASNo. 144, when we determine that the carrying value of applicablelong-lived assets may not be recoverable based upon the existence of one ormore of the above indicators of impairment, we evaluate whether the carryingamount of the asset exceeds the sum of the undiscounted cash flows expected toresult from the use and eventual disposition of that asset. If such acircumstance exists, we would measure an impairment loss to the extent thecarrying amount of the particular long-lived asset or group exceeds its fairvalue. We would determine the fair value based on a projected discounted cashflow method using a discount rate determined by our management to be commensuratewith the risk inherent in our current business model. In accordance with SFASNo. 86, when we determine that the carrying value of capitalized softwaredevelopment costs may not be recoverable, we evaluate whether the unamortizedcost exceeds the expected future net realizable value of the products. If theunamortized costs exceed the expected future net realizable value of theproducts, the excess amount is written off. Changes in judgments on any ofthese factors could impact the value of the asset being evaluated.

*(l) RevenueRecognition*

Wave’s business modeltargets revenues from various sources including: licensing of EMBASSY TrustSuite, Wavexpress’ broadband media distribution and eTMS software products anddevelopment contracts. Many of our sales arrangements includemultiple-elements, and/or required significant modification or customization ofour software.

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

F-18

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

**PRODUCTS—SOFTWARE**

Revenue from delivered elements of one-time chargelicensed software is recognized at the inception of the license term, providedWave has vendor-specific objective evidence of the fair value of eachundelivered element, for arrangements that contain multiple elements. Revenueis deferred for undelivered elements for these arrangements. Revenue is alsodeferred for the entire arrangement, if vendor-specific objective evidence doesnot exist for each undelivered contract element. Examples of undeliveredelements in which the timing of delivery is uncertain include contractualelements that give customers rights to any future upgrades at no additionalcharge or future maintenance that is provided within the overall price. Therevenue that is deferred for any contract element is recognized when all of therevenue recognition criteria have been met for that element.

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

**SERVICES**

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

*(m)    Accountingfor Warrants Containing Cash Settlement Provisions*

Wave follows the FASB’s Emerging Issues Task Forcepronouncement No. 00-19 (“EITF 00-19”) to account forderivative financial instruments indexed to, and settled in our own stock. Thesewould include financial instruments such as options or warrants to purchaseWave stock, but does not include employee stock options. EITF 00-19requires that freestanding financial instruments of this nature be classifiedas an asset or liability at fair value, in the event that the contractunderlying any such financial instruments includes a net cash settlementprovision. In addition, EITF 00-19 requires any such asset or liabilityto be marked to market at the end of each period, with any resulting differencein fair value to be recorded as income or loss, through the company’s statementof operations, depending upon whether the difference results in a gain or loss.

F-19

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

On November 18, 2003,Wave granted warrants to purchase 931,309 shares of Wave common stock at anexercise price of $2.62 per share, in connection with a private placement ofcommon stock with a group of accredited investors. The warrants have athree-year term. The contract underlying the warrants includes a provision thatwould require Wave to pay liquidated damages in cash to the warrant holders ifthe warrants are “in the money” and the registration statement underlying suchshares ceases to remain continuously effective. Because of this provision, thecontract is considered to contain a net cash settlement provision as defined inEITF 00-19. Although the registration statement was declared effective bythe Securities Exchange Commission on February 12, 2004, the net cashsettlement provision still applies because of the stipulation that it mustremain continuously effective and there are circumstances that couldpotentially cause the registration statement to cease to remain effective. Accordingly,Wave recorded a liability in its balance sheet that was valued at $2,794 as of December 31,2005, and $493,128 as of December 31, 2004. These values were arrived atutilizing the Black-Scholes option pricing model with the followingassumptions:

| ** **                       | ** ** | **As of December 30, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Expected life  remaining (years) |       |                                            | .90        |                                            |       |   | 1.92 |   |   |
| Interest rate                    |       |                                            | 4.36       | %                                               |       |   | 3.0 | % |   |
| Volatility                       |       |                                            | 62         | %                                               |       |   | 128 | % |   |
| Dividend yield                   |       |                                            | 0          | %                                               |       |   | 0 | % |   |

 

The decrease in fair valueof the liability associated with the warrants of $490,334 and $498,723  was recorded as an unrealized gain in Wave’sstatement of operations in the year ended December 31, 2005 and 2004, inaccordance with EITF 00-19.

**(4)**   Related PartyTransactions

*(a)   NotesReceivable from Officers*

Prior to the enactment of the Sarbanes-Oxley Act of2002, Wave had made loans to certain of its officers. Some of the loans wereextended beyond their original terms by one year. These loans and theextensions thereon, were granted to the officers, prior to the enactment of theSarbanes-Oxley Act of 2002, to allow them to satisfy certain personal financialobligations that would otherwise have required them to liquidate some of theirholdings of Wave shares. The loans were granted as a means to mitigate apotential unfavorable impact to Wave’s share price as a result of the officersselling large blocks of shares. All loans to officers have been paid in full,therefore there were no balances owed on the loans as of December 31, 2005and 2004. Details with respect to the officer loans are as follows:

On March 26, 2001 Wave made a personal loan to Mr. GerardT. Feeney, Senior Vice President, Chief Financial Officer and Secretary of Waveas evidenced by a demand note for $250,000, which sum was due and payable toWave on March 26, 2002 and bore interest at a rate per annum equal to 1%over the prime interest rate. Interest on the loan accrued monthly and waspayable at maturity. The terms of the loan were substantially equivalent tomarket terms at that time. The due date of the demand note was subsequentlyextended until March 26, 2003. As of March 26, 2003 the loan balance,including accrued interest thereon was $281,399. On March 27, 2003, theCompensation Committee approved a bonus in an amount equal to Mr. Feeney’sobligations with respect to such loan and accrued interest. Proceeds of thisbonus were used to repay the loan and all interest accrued on such loan. Thebonus was granted during the year so that Mr. Feeney could repay his loan,rather than at fiscal year end when bonuses are usually awarded. The factorsused in granting this extraordinary bonus were the amount of the loan, theability to repay the loan and the impact that non-repayment of the loan wouldhave on Mr. Feeney’s abilities to fulfill his duties for Wave. Wave nolonger intends to award bonuses to executive officers or directors in 

F-20

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**(4)**   Related Party Transactions (Continued)

order for them to repayoutstanding loans because there are no outstanding loans to any currentexecutive officers or directors and the Sarbanes-Oxley Act of 2002 prohibitsany future such loans. The largest aggregate amount outstanding with respect toindebtedness of Mr. Feeney during the year ended December 31, 2003was $281,399. Wave has taken this bonus into account when considering futurebonus awards to Mr. Feeney.

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

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

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

*(b)   Paymentsto Related Party*

In March 2003, Mr. Peter Sprague, who is theformer Chairman of Wave, was appointed Chairman and Chief Executive Officer ofWavexpress. Mr. Sprague was paid $129,000, $175,667 and $185,000 for theyears ended December 31, 2005, 2004 and 2003, respectively in salary inthis capacity (for the year ended December 31, 2003, $138,750 was paid byWavexpress for Mr. Sprague’s duties as an officer of Wavexpress and$46,250 was paid by Wave for Mr. Sprague’s duties as an officer ofWave.)   Mr. Peter Sprague is thefather of Wave’s President and Chief Executive Officer, Steven Sprague.

On August 1, 1997,Michael Sprague became an employee of Wave, at an annual salary of $110,000. OnNovember 1, 1999 he became an employee of Wavexpress at an annual salaryof $120,000 and was paid $150,000, $150,000 and $143,750 for the years ended December 31,2005, 2004 and 2003, respectively. Michael Sprague is the brother of StevenSprague and the son of Wave’s former Chairman, Peter Sprague.

F-21

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**(5)**      Property and Equipment

Propertyand equipment as of December 31 consisted of the following:

| ** **                                       | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
| Computer  Equipment                              |       | $          | 6,003,899  |       | $          | 5,848,420 |   |
| Furniture,  fixtures and improvements            |       | 887,843    |       | 882,492    |       |
| Computer software                                |       | 4,821,247  |       | 4,821,248  |       |
|                                             |       | 11,712,989 |       | 11,552,160 |       |
| Less: Accumulated  depreciation and amortization |       | 10,958,836 |       | 10,117,107 |       |
| Total                                            |       | $          | 754,153    |       | $          | 1,435,053 |   |

 

Computer software includes$1,864,256 of capitalized software development costs pursuant to SFAS 86 as ofDecember 31, 2005 and 2004. Capitalized software pursuant to SFAS 86 isamortized over a three-year life using the straight-line method, once theproduct is ready to bring to market.

Depreciation andamortization expense on property and equipment amounted to approximately$842,000, $855,000 and $1,241,000 for the years ended December 31, 2005,2004, 2003, respectively.

**(6)          Accounts Payable and Accrued Expenses**

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

| ** **                                                      | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-----------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Accounts payable                                                |       | $         | 993,926    |      | $          | 819,278 |   |
| Accrued  consulting and professional fees                       |       | 472,290   |       | 531,165   |       |
| Accrued payroll  and related costs                              |       | 1,139,814 |       | 1,012,897 |       |
| Accrued rent                                                    |       | 53,905    |       | 77,670    |       |
| Annual report and  shareholders meeting                         |       | 77,073    |       | 80,404    |       |
| State &  local taxes payable                           |       | 92,397    |       | 72,472    |       |
| Accrued software  licenses                                      |       | 162,500   |       | 162,500   |       |
| Accrued expenses  in connection with sales of Wave common stock |       | 54,219    |       | 43,544    |       |
| Other accrued  expenses                                         |       | 43,026    |       | 100,134   |       |
| Total accounts payable  and accrued expenses                    |       | $         | 3,089,150  |      | $          | 2,900,064 |   |

 

**(7)**                               PreferredStock

***(a)****         **Series H Preferred Stock*

Wave has authorized2,000,000 shares of preferred stock having a par value of $.01 per share.

On April 30, 2003,Wave completed a private placement of 548.5 shares of its Series HConvertible Preferred Stock (the “Series H Stock”) and warrants topurchase Wave’s Class A Common Stock for an aggregate purchase price of$5,485,000, with a group of institutional and accredited investors. Waverealized aggregate proceeds of $4,780,540 net of commissions and other cashfees of $704,460, in connection with the transaction.  In addition, Wave incurred commissions of$315,971 for the fair market value of warrants granted to placement agents topurchase approximately 325,000 shares of Wave’s Class A Common Stock at$0.01. As of December 31, 2003 all 548.5 shares of Series H Stockwere converted at a conversion price of $0.76 into 7,217,105 shares of Class ACommon Stock. In addition, 2,632,311 shares of Class A Common Stock wereissued in connection with the exercise of Series H Warrants for netproceeds of $2,490,167. Series H Warrants to acquire 65,789 shares of Class ACommon Stock remain outstanding as of March 1, 2005, at an exercise priceof $1.13 per share.

F-22

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**(7)          Preferred Stock (Continued)**

Dividends on the Series HStock accrued on the initial liquidation preference amount of each share($10,000) at an annual rate of 10%, and would have increased to 12% on April 30,2004. Dividends were payable out of any assets legally available to paydividends when and if declared by the board of Directors of the Company, orupon liquidation or conversion of the Series H Stock. Dividend expense inconnection with converted Series H Stock (not including accretion ofdiscount on the Series H Stock) for the year ended December 31, 2003totaled $212,510.

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

| Class A  Common Shares if converted |   | 7,217,105 |      |
|------------------------------------------|--------|-----------|-----------|
| Closing price on  April 30, 2003    |   | $         | 0.98      |   |
| Aggregate fair  value upon conversion    |   | $         | 7,072,763 |   |
| Gross Proceeds of  Series H Stock   |   | 5,485,000 |      |
| Excess fair value upon  conversion       |   | $         | 1,587,763 |   |

 

As part of thetransaction, Wave issued to the investors warrants to purchase shares of Class ACommon Stock, with an initial exercise price of $1.13 per share and a five (5) yearlife (the “Series H Warrants” and, together with Series H Stock, the “Series HSecurities”). Initially, the Series H Warrants were exercisable for atotal of 3,608,558 shares of Class A Common Stock on the trading dayfollowing the date of Wave’s 2003 annual meeting of stockholders. If exercisedin full, the original Series H Warrants would have generated up to anadditional $4,077,671, at the initial exercise price.

During September 2003the terms of the Series H Purchase Agreement and other documents governingthe Series H Stock and the Series H Warrants were modified, pursuantto a letter agreement and waiver (collectively the “Waiver”) whereby, eachholder that executed the Waiver was required to convert their Series HStock on the effective date of the Waiver and agreed to allow Wave to reducetheir Series H Warrant shares by the holders’ proportion of a 900,000reduction in the total number of Series H Warrant shares. This allowed the holders of the Series HSecurities to convert and exercise their Series H Securities prior to theshareholder vote to approve or disapprove the issuance of shares because it wasno longer in excess of 19.99% of the Class A Common Stock outstandingbefore the issuance of the Series H Securities. In the absence of theseWaivers, any such conversion or exercise prior to the shareholder vote wouldhave violated Nasdaq listing requirements. Also, pursuant to the Waiver,the exercise price of the Series H Warrants was reduced from $1.13 to$1.00 for the holders that signed the Waiver.

In connection with theissuance of the Series H Stock and the Series H Warrants, Waverecorded a beneficial conversion feature discount of $2,903,146 in the quarterended June 30, 2003. In addition, $1,561,424 was allocated to the Series HWarrants as an additional discount to the Series H Stock. The remaininggross proceeds of $1,020,430 were allocated to commissions and fees on the Series HStock, therefore, no proceeds remained to allocate to the preferred stock. Wavefollowed the Financial Accounting Standards Board’s Emerging Issues Task Force(“EITF”) 98-5 and EITF 00-27 in determining the beneficialconversion feature, whereby the proceeds were first allocated to the Series HStock and the  

F-23

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**(7)          Preferred Stock (Continued)**

warrantson a relative fair value basis. Wave utilized the Black Scholes option pricingmodel to calculate the fair value of the Series H Warrants with thefollowing assumptions:

| Expected Life in  years |   | 5     |   |
|-------------------------|--------|-------|--------|
| Interest rate           |   | 3.0   | %      |
| Volatility              |   | 112.8 | %      |
| Dividend yield          |   | 0     | %      |

 

Thefair value of the Series H Stock was calculated as the number of shares ofClass A Common Stock that the Series H Stock is convertible into,multiplied by the closing price of Wave’s Class A Common Stock on Nasdaqon the closing date of this financing.  The value of the beneficial conversion featurewas calculated by multiplying the number of Class A Common shares that theSeries H Stock was convertible into by the intrinsic value per share,which was calculated as the closing price of Wave’s Class A Common Stockon Nasdaq as of April 30, 2003 less the effective conversion price of the Series HStock. The beneficial conversion feature and warrant discount were accreted asa dividend on a straight line basis, which approximated the effective yieldover the period from the date of issuance through the trading day followingWave’s annual meeting of stockholders in which stockholders would vote on theproposal to approve the issuance of shares of Class A Common Stock inexcess of 19.99% of the number of shares of Class A Common Stockoutstanding prior to April 30, 2003, upon the conversion and exercise ofshares of Series H Stock and the related Warrants, which was initiallyscheduled for August 27, 2003 and then amended on August 11, 2003 tobe held by November 17, 2003. As of December 31, 2003, the balance ofthe Series H Stock, net of all discounts, consisted of the following:

| Gross offering  proceeds                            |   | $          | 5,485,000 |   |
|-----------------------------------------------------|--------|------------|-----------|--------|
| Fees and  Commissions deducted from proceeds        |   | (704,459   | )         |
| Net Cash proceeds                                   |   | 4,780,541  |      |
| Placement agent  warrants                           |   | (315,970   | )         |
| Net Series H  Stock after all fees             |   | 4,464,571  |      |
| Additional Discounts:                               |   |       |      |
| Series H  Warrants                             |   | (1,561,425 | )         |
| Beneficial  Conversion Feature (BCF)                |   | (2,903,146 | )         |
| Total Additional  Discounts                         |   | (4,464,571 | )         |
| Net Series H  Stock after allocations          |   | -0-        |      |
| Accretion of Discounts:                             |   |       |      |
| Placement agent  warrants                           |   | 315,971    |      |
| Fees paid or  deducted from proceeds in cash        |   | 704,458    |      |
| Series H  Warrants                             |   | 1,561,425  |      |
| BCF                                                 |   | 2,903,146  |      |
| Total Accretion  of Discounts                       |   | 5,485,000  |      |
| Preferred Stock  value as of December 31, 2003 |   | 5,485,000  |      |
| Conversion of  548.5 shares of Series H Stock  |   | (5,485,000 | )         |
| Balance as of  December 31, 2003               |   | $          | -0-       |   |

 

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

F-24

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**(7)          Preferred Stock (Continued)**

***(b)****         **Series G Preferred Stock*

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

***(c)****          **Series F Preferred Stock*

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

***(d)****         **Series D Preferred Stock*

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

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

***(e)****          **Series C Preferred Stock*

In December of 1996,Wave raised $2,634,037 net of issuance costs of $365,963 ($101,964 of whichrelated to the value ascribed to warrants issued) through the placement of150,000 shares of Series C Preferred Stock pursuant to Regulation D of theAct. The Series C Preferred Stock had a stated value of $20 per share,which accrued dividends payable quarterly in cash at 6% per annum.

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

F-25

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**(7)          Preferred Stock (Continued)**

***(f)****            **Series B Preferred Stock*

In May of 1996, Waveraised $3,214,026, net of issuance costs of $285,974, through the placement of350 shares of Series B Preferred Stock (“Series B Preferred Stock”)pursuant to Regulation S of the Securities Act of 1933 (“the Act”). The Series BPreferred Stock had a stated value of $10,000 per share, accrued dividends forliquidation and conversion purposes at 6% per annum and ranked senior to Wave’sCommon Sock and Series C Convertible Preferred Stock (“Series CPreferred Stock”) and junior to the Series A Preferred Stock. Series BPreferred Stock was convertible by the holder, in increments, into Wave’s Class ACommon Stock. The Series B Preferred Stock was convertible at the lesserof 110% of the average closing bid price for the five days immediatelypreceding the issue date or 85% of the average closing bid price for the fivedays immediately preceding the conversion date.

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

***(g)****          **Series A Preferred Stock*

On October 19, 1992,the Board of Directors designated and issued 360 shares of this preferred stockof Wave as “Series A Cumulative Redeemable Preferred Stock” (“Series APreferred Stock”). The Series A Preferred Stock was issued in settlementof compensation owed to a former officer of Wave for services provided to Wave.The holder of the Series A Preferred Stock was entitled to receive adividend at the rate of $60 per share per annum, when and as declared by theBoard of Directors of Wave. Dividends were cumulative from the date of originalissue, and payable upon redemption. On August 11, 1999, Wave redeemedthese shares for a total payment of $506,440, including accrued and unpaiddividends.

**(8)**                               CommonStock

On December 5, 2005,Wave entered into a Securities Purchase Agreement, pursuant to which Wave soldand issued 5,982,906 shares of Class A Common Stock, par value $.01 pershare, to certain purchasers who are parties to the Purchase Agreement for an aggregatepurchase price of $3,500,000. The Common Shares were priced at $0.585 per share.JPC Capital Partners, Inc. (formerly Corpfin Inc.) (the “Placement Agent”),had entered into a placement agency agreement with Wave in which they agreed toact as placement agent in connection with the offering. Wave paid the PlacementAgent a fee equal to 4.0% of the gross proceeds of this offering. Wave realizednet proceeds of $3,340,890 after deducting placement agent and other feesassociated with the issuance of these securities.

On August 5, 2005,Wave entered into a securities purchase agreement, pursuant to which Waveagreed to sell and issue 4,000,000 shares of Class A Common Stock, parvalue $.01 per share, for $0.90 per share, to certain purchasers who are partiesto the Purchase Agreement for an aggregate purchase price of $3,600,000. ThePlacement Agent had entered into a placement agency agreement with Wave inwhich they agreed to act as a placement agent in connection with the offering. Wavehas agreed to pay the Placement Agent a fee equal to 4.0% of the gross proceedsof this offering. Wave realized net proceeds of $3,389,205 after deducting theplacement agent fees of $144,000 and additional legal and other fees associatedwith the issuance of these securities of $66,795.

On August 1, 2005,Wave received gross proceeds of $2,260,000 less placement agent fees of $90,400for net proceeds of $2,169,600, for the issuance of 2,000,000 shares of Class ACommon Stock upon partial exercise of a warrant that was granted to anaccredited investor as part of a securities purchase agreement with theaccredited investor, dated July 30, 2004. The warrants were exercised at aprice of $1.13 per share.

On March 15, 2005,Wave entered into a securities purchase agreement, pursuant to which Wave soldand issued 4,659,090 shares of Class A Common Stock, par value $.01 pershare for an aggregate purchase  

F-26

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**(8)          Common Stock (Continued)**

price of$4,100,000. The shares of Class A Common Stock were priced at $0.88. ThePlacement Agent, had entered into a placement agency agreement with Wave inwhich they agreed to act as placement agent in connection with the offering. Wavepaid the placement agent a fee equal to 4% of the gross proceeds of thisoffering. Wave realized net proceeds of $3,891,959 after deducting placementagent and other fees associated with the issuance of these securities, whichtotaled $208,041.

On December 16, 2004,Wave entered into a Securities Purchase Agreement, pursuant to which Wave soldand issued 5,484,790 shares of Class A Common Stock, par value $.01 pershare, to certain purchasers who are parties to this purchase agreement for anaggregate purchase price of $5,759,030. The Common Shares were priced at $1.05.The Placement Agent had entered into a placement agency agreement with Wave inwhich they agreed to act as placement agent in connection with the offering. Wavepaid the Placement Agent a fee equal to 4.0% of the gross proceeds of thisoffering. Wave realized net proceeds of $5,474,728 after deducting placementagent and other fees associated with the issuance of these securities.

On July 30, 2004,Wave entered into a securities purchase agreement, pursuant to which Wave soldand issued 3,529,412 shares of Class A Common Stock, par value $.01 pershare for an aggregate purchase price of $3,000,000. The shares of Class ACommon Stock were priced at $0.85. Wave realized net proceeds of $2,777,897after deducting placement agent and other fees associated with the issuance ofthese securities. Wavealso granted warrants to purchase up to 4,411,765 shares of Class A CommonStock, in connection with this securities purchase agreement.

The warrants granted inthis transaction were made up of two different series, Series A andSeries B. The Series A warrants were exercisable for up to 3,529,412shares of Class A Common Stock at an exercise price of $1.15 per share.The Series A warrants were exercisable from January 30, 2005, untilAugust 1, 2005. The Series B warrants are exercisable for up to882,353 shares of Class A Common Stock at an exercise price of $1.30 pershare. The Series B warrants are exercisable from July 30, 2005,until January 30, 2006. The Series A and Series B warrantsissued in this transaction carries a subsequent equity clause that requiresWave to adjust the initial exercise price, pro-rata, for any subsequent equitysales that are made at a price that is lower than the initial exercise price.As a result several sales of common stock subsequent to the July 30, 2004securities purchase agreement, the exercise prices of the Series A andSeries B warrants were adjusted to $1.13 and $1.20, respectively, inaccordance with the formula pursuant to the warrant agreements. On August 1,2005 a Series A Warrant holder exercised a portion of the Series AWarrant for a total of 2,000,000 shares at an exercise price of $1.13 pershare, for aggregate gross proceeds of $2,260,000, less placement agent fees of$90,400, for net proceeds of $2,169,600. The remaining Series A warrantsfor 1,529,412 shares expired on August 1, 2005. All of the Series BWarrants granted in connection with the July 30, 2004 securitiespurchase  agreement remain outstanding asof December 31, 2005.

Wave also granted thepurchaser a 90-day additional investment right and two series ofwarrants. The additional investment right granted in this transaction allowedthe purchaser to purchase up to 3,529,412 additional shares of Class ACommon Stock at a price of $1.00 per share, and expired on November 2,2004 unexercised. These shares would have been drawn-down off of the shelfregistration statement, had the investment right been exercised.

The Placement Agententered into a placement agency agreement with Wave in which they have agreed toact as placement agent in connection with the offering. Wave has agreed to paythe Placement Agent a fee equal to 4.0% of the actual gross proceeds from thesale of the shares and exercise of the investment rights and warrants referredto above.

F-27

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**(8)   Common Stock(Continued)**

All of the above shares were drawn-down off of a shelfregistration statement which was filed by Wave on April 15, 2004 anddeclared effective by the Securities and Exchange Commission (the “SEC”) on May 10,2004.

On December 1, 2005 Wave sold 238,666 shares of Class ACommon Stock to Wave and Wavexpress employees for $0.68 per share, pursuant tothe Wave 2004 Employee Stock Purchase Plan. Wave received proceeds of $162,293,from the sale of these shares.

On June 1, 2005 Wave sold 253,475 shares of Class ACommon Stock to Wave and Wavexpress employees for $0.7565 per share, pursuantto the Wave 2004 Employee Stock Purchase Plan. Wave received proceeds of$191,754, from the sale of these shares.

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

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

On February 2, 2001 Wave issued 2,000,000 sharesof its Class A Common Stock, at a price of $7.16 per share, for an aggregatepurchase price of $14,312,800 to acquire 3,600,000 shares of the Series BPreferred Stock of BIZ, then a privately held company, in a private placementexempt from registration under code section 4(2) of the Securities Act of1933, as amended. Wave’s investment in BIZ represented approximately 17.8% ofthe outstanding capital stock of BIZ. On August 24, 2001 Litronic, Inc.(“Litronic”), a provider of authentication and encryption security technology,completed a merger with BIZ to form SSP Solutions. SSP Solutions trades on theNASDAQ National Stock Market as SSPX. As a result of the merger, Wave’s3,600,000 shares of BIZ were converted into 3,083,083 shares of common stock ofSSP.

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

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

F-28

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**(8)**   Common Stock (Continued)

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

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

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

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

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

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

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

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

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

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

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**(8)**   Common Stock (Continued)

any person or group ofpersons acquires beneficial ownership of 20% or more of the outstanding votingsecurities of Wave. The Class B Common Stock is convertible into shares ofClass A Common Stock at any time. The classes of Common Stock are alike inall other respects.

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

Two principal stockholdersdid not acquire the full amount of shares to which they were entitled. Most ofthe additional proportionate shares that these stockholders would have beencredited with were offered instead to certain officers, employees andstockholders for $.003 per share. To the extent that these rights were offeredto the individuals as compensation for services rendered to Wave, compensationexpense equal to the difference between the estimated fair value as of the dateof issuance and the purchase price of the stock was recorded. The estimatedfair value of the Common Stock was determined based on sales to third partiesnear the date of issuance. Compensation expense associated with the issuance ofthese shares of $430,250 is included in the accompanying consolidated statementof operations for the period from inception to December 31, 2005.

**(9)**   Options andWarrants

*1994 Plans*

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

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

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

The Stockholders of Wave have since, authorizedcertain changes to the Directors’ Plan. In February 1995, the annualoption grant for directors was increased from a total of 2,000 shares of Class ACommon Stock to 10,000 shares of Class A Common Stock. In July 1995,the Board authorized an increase to the total number of shares subject to theDirectors’ Plan from 200,000 shares to 500,000 shares. In  

F-30

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**(9)**   Options and Warrants (Continued)

November 1998, thestockholders of Wave authorized an increase to the total number of sharessubject to the Directors’ Plan from 500,000 shares to 1,000,000 shares. Thestockholders also amended the Directors’ Plan to provide that options issued tonon-employee directors under such plan vest on the day following the grant. (Initialoption grants under the Directors’ Plan vested one-third upon grant, andone-third on each of the first and second anniversaries. Annual option grantsvested 25% after each three-month period following grant.)  In June 2004, Wave’s Stockholdersapproved an additional amendment to the Directors Plan to extend the terminationdate of the Directors’ Plan from January 18, 2004 to January 18,2009.

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

*The 1996 Plan*

**In September 1996, the Boardof Directors authorized and the shareholders approved the establishment of the1996 Performance Stock Option Plan (the “1996 Plan”). The initial number ofshares of Class A Common Stock subject to the 1996 Plan was 800,000. Theterms of the 1996 Plan are similar to those of the Plan. Options are grantedwith exercise prices that approximate fair market value at the date of grant.**

F-31

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**(9)**   Options andWarrants (Continued)

**Summary of OptionActivity**

Asummary of option activity for all Wave option plans through December 31,2005 follows:

| ** **                         | ** ** | **Class A and B shares** | ** ** | **Weighted average** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|---------------------------|------------|
| ** **                         | ** ** | **subject to option**              | ** ** | **exercise price**   | ** ** |
| Balance at January 1,  1991   |       |                                         | —     |                      |       |   | $ | — |   |   |
| Options granted                    |       |                                         | 30,000     |                      |       |   | 1.67 |   |   |
| Balance at  December 31, 1991 |       |                                         | 30,000     |                      |       |   | 1.67 |   |   |
| Options granted                    |       |                                         | 816,750    |                      |       |   | 1.18 |   |   |
| Balance at  December 31, 1992 |       |                                         | 846,750    |                      |       |   | 1.20 |   |   |
| Options granted                    |       |                                         | 949,186    |                      |       |   | 3.10 |   |   |
| Balance at December 31,  1993 |       |                                         | 1,795,936  |                      |       |   | 2.20 |   |   |
| Options granted                    |       |                                         | 310,200    |                      |       |   | 3.05 |   |   |
| Options canceled                   |       |                                         | (108,500   | )                         |       |   | 3.38 |   |   |
| Balance at  December 31, 1994 |       |                                         | 1,997,636  |                      |       |   | 2.27 |   |   |
| Options granted                    |       |                                         | 777,850    |                      |       |   | 2.22 |   |   |
| Options canceled                   |       |                                         | (349,205   | )                         |       |   | 2.11 |   |   |
| Options exercised                  |       |                                         | (681,700   | )                         |       |   | 0.64 |   |   |
| Balance at  December 31, 1995 |       |                                         | 1,744,581  |                      |       |   | 2.92 |   |   |
| Options granted                    |       |                                         | 1,342,075  |                      |       |   | 2.65 |   |   |
| Options canceled                   |       |                                         | (503,879   | )                         |       |   | 3.20 |   |   |
| Options exercised                  |       |                                         | (214,091   | )                         |       |   | 1.97 |   |   |
| Balance at  December 31, 1996 |       |                                         | 2,368,686  |                      |       |   | 2.79 |   |   |
| Options granted                    |       |                                         | 707,914    |                      |       |   | 1.02 |   |   |
| Options canceled                   |       |                                         | (676,741   | )                         |       |   | 1.57 |   |   |
| Options exercised                  |       |                                         | (70,326    | )                         |       |   | 1.90 |   |   |
| Balance at  December 31, 1997 |       |                                         | 2,329,533  |                      |       |   | 2.38 |   |   |
| Options granted                    |       |                                         | 5,756,893  |                      |       |   | 2.47 |   |   |
| Options canceled                   |       |                                         | (707,384   | )                         |       |   | 2.48 |   |   |
| Options exercised                  |       |                                         | (78,653    | )                         |       |   | 1.94 |   |   |
| Balance at  December 31, 1998 |       |                                         | 7,300,389  |                      |       |   | 2.40 |   |   |
| Options granted                    |       |                                         | 1,925,447  |                      |       |   | 10.15 |   |   |
| Options canceled                   |       |                                         | (450,378   | )                         |       |   | 3.51 |   |   |
| Options exercised                  |       |                                         | (964,000   | )                         |       |   | 1.69 |   |   |
| Balance at  December 31, 1999 |       |                                         | 7,811,458  |                      |       |   | 4.33 |   |   |
| Options granted                    |       |                                         | 3,444,037  |                      |       |   | 13.58 |   |   |
| Options canceled                   |       |                                         | (905,145   | )                         |       |   | 12.33 |   |   |
| Options exercised                  |       |                                         | (2,030,958 | )                         |       |   | 2.51 |   |   |
| Balance at  December 31, 2000 |       |                                         | 8,319,392  |                      |       |   | 7.90 |   |   |
| Options granted                    |       |                                         | 2,934,272  |                      |       |   | 3.46 |   |   |
| Options canceled                   |       |                                         | (1,128,327 | )                         |       |   | 8.16 |   |   |
| Options exercised                  |       |                                         | (473,511   | )                         |       |   | 1.42 |   |   |
| Balance at  December 31, 2001 |       |                                         | 9,651,826  |                      |       |   | 6.85 |   |   |

 

F-32

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**(9)**   Options and Warrants(Continued)

| ** **                         | ** ** | **Class A and B shares** | ** ** | **Weighted average** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|---------------------------|------------|
| ** **                         | ** ** | **subject to option**              | ** ** | **exercise price**   | ** ** |
| Balance at  December 31, 2001 |       |                                         | 9,651,826  |                      |       |   | 6.85 |   |   |
| Options granted                    |       |                                         | 1,607,959  |                      |       |   | 1.94 |   |   |
| Options canceled                   |       |                                         | (1,033,989 | )                         |       |   | 8.44 |   |   |
| Options exercised                  |       |                                         | (42,553    | )                         |       |   | 1.04 |   |   |
| Balance at December 31, 2002  |       |                                         | 10,183,243 |                      |       |   | 5.94 |   |   |
| Options granted                    |       |                                         | 2,287,670  |                      |       |   | 1.41 |   |   |
| Options canceled                   |       |                                         | (1,589,495 | )                         |       |   | 8.08 |   |   |
| Options exercised                  |       |                                         | (1,340,739 | )                         |       |   | 2.14 |   |   |
| Balance at December 31, 2003  |       |                                         | 9,540,679  |                      |       |   | 5.03 |   |   |
| Options granted                    |       |                                         | 2,344,538  |                      |       |   | 1.22 |   |   |
| Options canceled                   |       |                                         | (515,355   | )                         |       |   | 6.19 |   |   |
| Options exercised                  |       |                                         | (32,809    | )                         |       |   | 1.04 |   |   |
| Balance at December 31, 2004  |       |                                         | 11,337,053 |                      |       |   | $ | 4.20 |   |   |
| Options granted                    |       |                                         | 1,509,625  |                      |       |   | 1.00 |   |   |
| Options canceled                   |       |                                         | (478,068   | )                         |       |   | 3.77 |   |   |
| Options exercised                  |       |                                         | -0-        |                      |       |   | 0.00 |   |   |
| Balance at  December 31, 2005 |       |                                         | 12,368,610 |                      |       |   | $ | 3.82 |   |   |

 

At December 31, 2005, there were 8,902,971options exercisable at prices ranging from $0.69 to $37.50 and there were anadditional 8,324,915 shares available for grant.

Thefollowing table summarizes information about stock options outstanding at December 31,2005:

| ** **                         | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Exercise Price Range** | ** ** | ** **                   | ** ** | **Number  Outstanding**      | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.69 - $1.04                      |       | 3,457,994                    |       |                         | 8.5 years  |   |   |   | $ | 0.94 |   |   | 1,052,336 |   |   | $ | 0.93 |   |   |
| $1.05 - $1.58                      |       | 992,979                      |       |                         | 4.8 years  |   |   |   | 1.27 |   |   | 866,081 |   |   | 1.28 |   |   |
| $1.59 - $2.39                      |       | 2,899,986                    |       |                         | 7.1 years  |   |   |   | 1.79 |   |   | 1,976,903 |   |   | 1.84 |   |   |
| $2.40 - $3.60                      |       | 323,667                      |       |                         | 3.6 years  |   |   |   | 3.35 |   |   | 313,667 |   |   | 3.37 |   |   |
| $3.61 - $5.42                      |       | 2,840,881                    |       |                         | 3.6 years  |   |   |   | 3.87 |   |   | 2,840,881 |   |   | 3.87 |   |   |
| $5.43 - $8.15                      |       | 106,540                      |       |                         | 4.0 years  |   |   |   | 6.76 |   |   | 106,540 |   |   | 6.76 |   |   |
| $8.16 - $12.24                     |       | 870,863                      |       |                         | 4.0 years  |   |   |   | 11.77 |   |   | 870,863 |   |   | 11.77 |   |   |
| $12.25 - $18.38                    |       | 624,450                      |       |                         | 4.3 years  |   |   |   | 14.80 |   |   | 624,450 |   |   | 14.80 |   |   |
| $18.39 - $27.59                    |       | 219,250                      |       |                         | 4.6 years  |   |   |   | 19.61 |   |   | 219,250 |   |   | 19.61 |   |   |
| $27.60 - $37.50                    |       | 32,000                       |       |                         | 4.1 years  |   |   |   | 31.64 |   |   | 32,000 |   |   | 31.64 |   |   |
| Total                              |       | 12,368,610                   |       |                         | 6.0 years  |   |   |   | $ | 3.82 |   |   | 8,902,971 |   |   | $ | 4.86 |   |   |
|                                    |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-33

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**(9)**   Optionsand Warrants (Continued)

*1999 WavexpressStock Incentive Plan*

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

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

Stockoption activity during 2005, 2004 and 2003 is as follows:

| ** **                                            | ** ** | **2005**                   | ** ** | **2004**                               | ** ** | **2003**                   | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Balance at  Beginning of year                         |       | 1,302,829                  |       |                                   | $          | 1.21                       |       |   | 1,315,062 |   |   | $ | 1.21 |   |   | 1,402,841 |   |   | $ | 1.21 |   |   |
| Granted                                               |       | —                     |       |                                   |       |                       |       | 24,500 |   |   | 1.20 |   |   | — |   |   | — |   |   |
| Canceled                                              |       | (610,933                   | )          |                                   | 1.20       |                       |       | (36,733 | ) |   | 1.20 |   |   | (87,779 | ) |   | 1.20 |   |   |
| Balance at end of  year                               |       | 691,896                    |       |                                   | 1.23       |                       |       | 1,302,829 |   |   | 1.21 |   |   | 1,315,062 |   |   | 1.21 |   |   |
| Exercisable at  end of year                           |       | 682,229                    |       |                                   | 1.23       |                       |       | 1,210,029 |   |   | 1.21 |   |   | 927,105 |   |   | 1.22 |   |   |
| Additional shares  available for grant at end of year |       | 1,780,327                  |       |                                   |       |                       |       | 1,169,394 |   |   |   |   |   | 1,157,161 |   |   |   |   |   |

 

Theper share weighted-average fair value of stock options granted during 2004 was$0.72, on the date of grant using a Black-Scholes option-pricing model with thefollowing weighted-average assumptions:

| ** **               | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|
| Expected dividend  yield |       | 0        | %          |
| Risk-free  interest rate |       | 3        | %          |
| Expected  Volatility     |       | 114      | %          |
| Expected life            |       | 3 years  |       |

 

No options were granted under the Wavexpress stockoption plan during the years ended December 31, 2005 or December 31,2003.

Thefollowing table summarizes information about Wavexpress’ stock optionsoutstanding at December 31, 2004:

| ** **          | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**         | ** ** |
|---------------------|------------|------------------------------|------------|--------------------------------------|------------|
| ** **          | ** ** | ** **                   | ** ** | **Weighted**                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **                   | ** ** | **Average**                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | **Number**                   | ** ** | **Remaining  Contractual Life** | ** ** | **Weighted  Average** | ** ** | **Number** | ** ** | **Weighted  Average** | ** ** |
| **Exercise  Price** | ** ** | ** **                   | ** ** | **Outstanding**                      | ** ** | **(in years)** | ** ** | **Exercise Price** | ** ** | **Exercisable** | ** ** | **Exercise Price** | ** ** |
| $1.20               |       |                         | 683,699    |                                 |       |   | 6.0 |   |   |   | $ | 1.20 |   |   |   | 674,032 |   |   |   | $ | 1.20 |   |   |
| $3.00 - $4.50       |       |                         | 8,197      |                                 |       |   | 4.6 |   |   |   | $ | 3.37 |   |   |   | 8,197 |   |   |   | $ | 3.37 |   |   |
| $1.20 - $4.50       |       |                         | 691,896    |                                 |       |   | 6.0 |   |   |   | $ | 1.23 |   |   |   | 682,229 |   |   |   | $ | 1.23 |   |   |
|                     |            |                              |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-34

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**(9)**   Options and Warrants (Continued)

*Warrants*

On December 5, 2005, Wave granted warrants topurchase up to 1,093,750 shares of Class A Common Stock, in connectionwith a securities purchase agreement, pursuant to which Wave sold and issued5,982,906 shares of Class A Common Stock, par value $.01 per share for anaggregate purchase price of $3,500,000. The warrants are exercisable at anexercise price of $0.80 per share and expire on June 5, 2006. If exercisedin full, the warrants granted in connection with this financing will generateup to an additional $875,000, at the exercise price. The shares of Class ACommon Stock issuable upon exercise of theses warrants are to be drawn-down offof the shelf registration statement, if the warrants are exercised. All of thewarrants granted in connection with the December 5, 2005 securitiespurchase  agreement remain outstanding asof December 31, 2005.

On July 30, 2004, Wave granted warrants topurchase up to 4,411,765 shares of Class A Common Stock, in connectionwith a securities purchase agreement, pursuant to which Wave sold and issued3,529,412 shares of Class A Common Stock, par value $.01 per share for anaggregate purchase price of $3,000,000. The warrants granted in thistransaction were made up of two different series, Series A and Series B.The Series A warrants were exercisable for up to 3,529,412 shares of Class ACommon Stock at an exercise price of $1.15 per share. The Series Awarrants were exercisable from January 30, 2005, until August 1, 2005.The Series B warrants are exercisable for up to 882,353 shares of Class ACommon Stock at an exercise price of $1.30 per share. The Series Bwarrants are exercisable from July 30, 2005, until January 30, 2006. Theshares of Class A Common Stock issuable upon exercise of the Series Awarrants and Series B warrants are also to be drawn-down off of the shelfregistration statement, if the warrants are exercised. The Series A and Series Bwarrants issued in this transaction carries a subsequent equity clause thatrequires Wave to adjust the initial exercise price, pro-rata, for anysubsequent equity sales that are made at a price that is lower than the initialexercise price. As a result several sales of common stock subsequent to the July 30,2004 securities purchase agreement, the exercise prices of the Series Aand Series B warrants were adjusted to $1.13 and $1.20, respectively, inaccordance with the formula pursuant to the warrant agreements. On August 1,2005 a Series A Warrant holder exercised a portion of the Series AWarrant for a total of 2,000,000 shares at an exercise price of $1.13 pershare, for aggregate gross proceeds of $2,260,000, less placement agent fees of$90,400, for net proceeds of $2,169,600. The remaining warrants for 1,529,412expired on August 1, 2005. All of the Series B Warrants granted inconnection with the July 30, 2004 securities purchase  agreement remain outstanding as of December 31,2005 and expired unexercised on January 30, 2006.

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

On November 18, 2003, Wave granted warrants topurchase 931,309 shares of Class A Common Stock at an exercise price of$2.62 per share in connection with a private placement to a group of accreditedinvestors. The warrants have a three year term.  In addition, in connection with thetransaction, Wave granted additional warrants to purchase 161,595 shares of Class ACommon Stock as commissions to placement agents in connection with the privateplacement. The warrants granted to the placement agents are also exercisable ata price of $2.62 per share and have a 3 year life as well. If exercised in full, the warrants granted inconnection with this financing will generate up to an additional $2,863,000, atthe exercise price. All of the warrants granted in connection with the November 18,2003 private placement remain outstanding as of December 31, 2005.

F-35

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**(9)**   Options and Warrants (Continued)

On April 30,2003, Wave granted the Series HWarrants to purchase shares of Class A Common Stock, with an initialexercise price of $1.13 per share and a five (5) year life. Initially, theSeries H Warrants were exercisable for a total of 3,608,556 shares of Class ACommon Stock on the trading day following the date of Wave’s 2003 annualmeeting of stockholders. During September 2003 the terms of the Series HPurchase Agreement and other documents governing the Series H Stock andthe Series H Warrants were modified,as discussed in note 8(a), above. As of December 31, 2003,2,632,315 shares of Class A Common Stock were issued in connection withthe exercise of Series H Warrants for net proceeds of $2,565,167.Series H Warrants to acquire 65,789 shares of Class A Common Stockremain outstanding as of December 31, 2005.

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

In connection with a software development agreement thatWave entered into with Archon Technologies, Inc. (“Archon”), Wave issuedto Archon a warrant to purchase 50,000 shares of Wave Class A Common Stockat $3.48 per share. The warrant became exercisable on November 9, 2002,and expires on November 9, 2007.

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

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

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

As a result of the successful placement of 350 sharesof Series B Preferred Stock, a consultant from Digital Media Group, Inc.was issued warrants by Wave to purchase 15,000 Class A Common shares at aprice of $3.09 per share. These warrants are exercisable for ten yearscommencing in March 1996, and are still outstanding.

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

In connection with the acquisition of WIN, Wave issueda warrant that allowed the holder the ability to purchase unregistered sharesof Wave’s Class A Common Stock at a price of $1.25 per share at theearlier of the conversion of a note or April 18, 1998 for a period of fiveyears. The number of shares able to 

F-36

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**(9)**   Options and Warrants (Continued)

be purchased under thiswarrant is based on a formula of $170,000 divided by 80% of the fair marketvalue of the Class A Common Stock at the time of conversion. This warrantwas subsequently extended one year by issuing 100,000 additional warrants to beexercised at prices ranging from $1.49 to $3.43. These warrants were exercisedduring July 1999.

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

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

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

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

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

A summary of warrants outstanding at December 31,2005, follows:

 

| ** **              | ** ** | **Warrants Outstanding** | ** ** | **Warrants Exercisable** | ** ** |
|-------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | ** **                    | ** ** | **Weighted**                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Exercise Price** | ** ** | ** **                    | ** ** | **Number of  Shares**    | ** ** | **Average  Remaining  Contractual Life  (in years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.80 - $1.20           |       | 1,254,367                     |       |                          | 1.1        |   |   |   | $ | 0.83 |   |   | 1,254,367 |   |   | $ | 0.83 |   |   |
| $1.21 - $1.80           |       | 896,891                       |       |                          | 0.2        |   |   |   | $ | 1.24 |   |   | 896,891 |   |   | $ | 1.24 |   |   |
| $1.81 - $2.70           |       | 1,092,904                     |       |                          | 0.9        |   |   |   | $ | 2.62 |   |   | 1,092,904 |   |   | $ | 2.62 |   |   |
| $2.71 - $3.48           |       | 65,000                        |       |                          | 1.5        |   |   |   | $ | 3.39 |   |   | 65,000 |   |   | $ | 3.39 |   |   |
|                    |       | 3,309,162                     |       |                          | 0.8        |   |   |   | $ | 1.58 |   |   | 3,309,162 |   |   | $ | 1.58 |   |   |
|                         |            |                               |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Employee StockPurchase Plan*

In November 2004, theBoard of Directors adopted the Wave Systems Corp. 2004 Employee Stock PurchasePlan (the “Purchase Plan”) pursuant to which a total of 3,000,000 shares ofWave’s Common 

F-37

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**(9)**   Options and Warrants (Continued)

Stockmay be sold to eligible employees at a 15% discount from the market value ofthe shares. Under the terms of the Purchase Plan, employees may elect to havewithheld, up to 15% of their base earnings to purchase these shares during eachoffering period, up to a maximum of $25,000 in market value of Wave CommonStock. Offering periods commence on May 1st and December 1st and arefor a period of six months. The purchase price under the Purchase Plan is 85%of the lesser of the market price on the beginning or the ending of theoffering period. Approximately 49% of eligible employees participated in thePurchase Plan during 2005. The Purchase Plan was ratified by a shareholder voteat Wave’s 2005 annual shareholder meeting on May 23, 2005. For the yearended December 31, 2005 employees purchased 492,141 shares of Wave Class ACommon Stock at an average share price of $0.72 per share, for an aggregate of$354,047 in proceeds to Wave.

**(10)**                        Investments

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

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

In August 2004, SSP merged with SaflinkCorporation. Pursuant to the merger agreement between SSP and Saflink, holdersof SSP common stock were issued 0.6 shares of Saflink common stock for everyshare of SSP common stock held. At the time of the merger, Wave held 2,043,283shares of SSP, which were surrendered in exchange for 1,225,970 shares ofSaflink, in accordance with the 0.6 ratio.

Asdetailed in the table below, Wave’s investments in marketable securities, whichwere classified as available-for-sale securities, consisted of 259,670 sharesof Saflink common stock valued at $721,880, as of December 31, 2004. Allmarketable securities were sold as of December 31, 2005.

| ** **                                                              | ** ** | **Shares** | ** ** | **Adjusted cost  basis** | ** ** | **Unrealized  gain (loss)** | ** ** | **Carrying value** | ** ** | **Value per  Share** | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|-------------------------------|------------|----------------------------------|------------|-------------------------|------------|---------------------------|------------|
| Balance of  investment in SSP Common Stock as of December 31, 2003 |       | 4,550,583  |       | $                             | 2,684,841  |                             | $          | 3,640,469               |       |                      | $          | 6,325,310 |   |   |   | $ | 1.39 |   |   |
| Sales of SSP  Common Stock                                              |       | (2,507,300 | )          | (1,479,308                    | )          | —                           |       |                    | (1,479,308 | )                         |       |   | (0.59 | ) |   |
| Conversion of  shares to Saflink Corp.                                  |       | (817,313   | )          | —                        |       | —                           |       |                    | —     |                      |       |   | — |   |   |
| Sales of Saflink  Corp. common stock                                    |       | (966,300   | )          | (950,195                      | )          | —                           |       |                    | (950,195   | )                         |       |   | (0.98 | ) |   |
| Other  comprehensive income—change in accumulated unrealized gain  |       | —     |       | —                        |       | (3,173,927                       | )          |                    | (3,173,927 | )                         |       |   | — |   |   |
| Balance as of  December 31, 2004                                   |       | 259,670    |       | $                             | 255,338    |                             | $          | 466,542                 |       |                      | $          | 721,880 |   |   |   | $ | 2.78 |   |   |
| Sales of Saflink  Corp. common stock                                    |       | (259,670   | )          | (255,338                      | )          | (466,542                         | )          |                    | (721,880   | )                         |       |   | (1.30 | ) |   |
| Balance as of December 31,  2005                                   |       | —     |       | $                             | —     |                             | $          | —                  |       |                      | $          | — |   |   |   | $ | — |   |   |

 

F-38

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**(10)**                        Investments(Continued)

During the year ended December 31,2005, Wave sold 259,670 shares of Saflink, in a series of separate sales, at anaverage selling price of $1.32 per share, realizing an aggregate gain from thesales of $80,971. For the year ended December 31, 2004, Wave sold2,507,300 shares of SSP in a series of separate sales, at an average sellingprice of $1.73 per share, and  966,300shares of Saflink at an average price of $2.50 per share realizing an aggregategain from the sales of $4,330,248.

Waverecorded unrealized holding gains on marketable equity securities included inother comprehensive income, as follows, for the years ended December 31:

| ** **                                                                                 | ** ** | **2005** | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|-----------|------------|
| Unrealized  holding gains                                                                  |       | $        | (385,571   | )          | $          | 1,156,321 |       | $ | 3,875,228 |   |
| Reclassification  adjustment for realized gains on securities sold, included in net income |       | (80,971  | )          | (4,330,248 | )          | (234,759  | )          |
| Net change in  accumulated unrealized gain                                                 |       | $        | (466,542   | )          | $          | 3,173,927 |       | $3,640,469 |   |
|                                                                                            |            |          |            |            |            |           |            |  |  |  |

 

**(11)**                        JointVentures

*(a)*                               Wavexpress

In April 1999, Wavejoined with Sarnoff Corporation to form a new joint venture, Wavexpress. Wavexpressdevelops secure broadband media distribution software products, infrastructureand content services. This technology and these services allow contentproviders and other enterprises to send digital content to properly equippedPCs. Consumers or enterprise end-users may receive this content directlythrough a secure network connection, thus enabling a new revenue stream forbroadcasters or cable television operators or a new content distribution methodfor enterprises.  On October 15,1999, Wave and Sarnoff signed a joint venture agreement that formallyestablished Wavexpress. Under this agreement, Sarnoff and its affiliatesreceived a 40% equity stake in Wavexpress. Wave received a 53% equity interest;and its affiliates, who purchased founders stock in April 1999 for anominal amount, owned the remaining 7% of the outstanding capital stock. Theaffiliates of Wave include Peter Sprague, former Chairman of Wave; Steven Sprague,Chief Executive Officer of Wave; certain members of the Board of Directors ofWave; and certain Wave employees.

Wave has funded Wavexpressthrough a series of convertible notes, some with attached warrants. The notesbear interest at rates of 2% to 3% above the prime rate of Chase Manhattan Bank.Generally, the notes are convertible into shares of Common Stock of Wavexpressat varying prices per share. In addition, some of the notes carry attachedwarrants that allow Wave to purchase additional shares of Wavexpress, generallyat the conversion price of the notes. As of December 31, 2005, Wave owned69% of Wavexpress while Sarnoff owned 26%. Through December 31, 2005, Wavehas funded Wavexpress with approximately $38 million in cash, plusapproximately $11.1 million in accrued interest. During 2001, some of thenotes, totaling approximately $9.5 million matured and were converted into1,826,570 shares of Wavexpress common stock. These amounts are eliminated inconsolidation.

Neither Sarnoff nor any ofthe other minority shareholders have provided or are obligated to providefunding to Wavexpress. Accordingly, the financial statements of Wavexpress havebeen included in the consolidated financial statements of Wave for all periodspresented. In addition, Wave has not recorded a minority interest in Wavexpressin the consolidated financial statements and therefore has reflected 100% ofWavexpress’ balance sheet and operating results in its consolidated financialstatements. Wavexpress has incurred net operating losses of $2.2 million, $3.4million and $3.9 million, for the years ended December 31, 2005, 2004 and2003, respectively.

F-39

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**(12)**                        Commitmentsand Contingencies

*Leases*

Summarizedbelow is a listing of properties leased by Wave pursuant to non-cancelable operatingleases. Our principal research and development activities are conducted at thePrinceton and Cupertino facilities.

| **Location**    | ** ** | ** ** | ** ** | **Annual  Lease Cost** | ** **     | **Lease Expiration  Date** | ** ** |
|-----------------|------------|------------|------------|-----------------------------|----------------|---------------------------------|------------|
| Lee, MA         |       | $          | 126,877    |                        |           | Jul. 2007                  |       |   |
| Princeton, NJ   |       | 157,367    |       |                        | Dec. 2009 |                            |       |
| Cupertino, CA   |       | 275,916    |       |                        | Feb. 2008 |                            |       |
| Orvault, France |       | 67,260     |       |                        | Sep. 2007 |                            |       |
| New York, NY(1) |       | 377,172    |       |                        | Apr. 2006 |                            |       |
| Total           |       | $          | 1,004,597  |                        |           |                            |       |   |

----

(1)          Wavexpressfacility

Futureminimum lease payments under non-cancelable operating leases (with initial or remaininglease terms in excess of one year) as of December 31, 2005 are as follows:

| 2006                          |   | $       | 766,430   |   |
|-------------------------------|--------|---------|-----------|--------|
| 2007                          |   | 533,643 |      |
| 2008                          |   | 218,212 |      |
| 2009                          |   | 171,623 |      |
| Thereafter                    |   | —  |      |
| Total minimum lease  payments |   | $       | 1,689,908 |   |

 

Rent expense for the yearsended December 31, 2005, 2004, 2003 amounted to approximately $957,000,$940,000 and $978,000, respectively.

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

*Securities and Exchange Commission Investigation*

On December 17, 2003,Wave received an Order by the Securities and Exchange Commission (the “Commission”)regarding a formal investigation. The focus of this investigation is on certainpublic statements made by Wave during and around August 2003, as well ascertain trading in Wave’s securities during such time. Wave is cooperatingfully with the Commission in this investigation. Wave is unable to predict theoutcome of this investigation at this time.

*Purported Class Actions*

A consolidated amendedclass action complaint is pending in the United States District Court for theDistrict of Massachusetts, naming Wave, its Chief Executive Officer and itsChief Financial Officer as defendants. Brumbaugh et al. v. Wave Systems Corp.et al., Civ. No. 04-30022 (D. Mass.) (MAP).

The purported class actionhas been filed by alleged purchasers of Wave’s Class A Common Stock duringthe purported class period July 31, 2003 through February 2, 2004. Thecomplaint claims that Wave and the named individuals violated Section 10(b) ofthe Securities Exchange Act of 1934 (the “1934 Act”), Rule 10(b)-5promulgated thereunder and Section 20(a) of the 1934 Act by publiclydisseminating materially false and misleading statements, relating to Wave’sagreements with Intel and IBM. The complaint does not specify the amount ofalleged damages plaintiffs seek to recover.

F-40

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**(12)        Commitments and Contingencies(Continued)**

Wave intends to defend theaction vigorously. Recently, the Court granted in part and denied in partdefendants’ motion to dismiss. The Court dismissed two but let stand sevenalleged misrepresentations or omissions. This is not a finding of fault orliability, it is a decision not entirely to dismiss plaintiffs’ pleading. Waveis unable to predict the outcome of this action.

*Derivative Actions*

A consolidated, purportedderivative action was pending in the United States District Court for theDistrict of Massachusetts,  Sachs v.Sprague et al. Civ. No. 04-30032 (D. Mass.) (MAP)  The complaint names all of Wave’s directorsduring the period July 2003 through February 2004 as defendants andalleges claims for breach of fiduciary duties and other claims based onallegations similar to the purported securities class action. Wave is alsonamed as a nominal defendant, although the actions are derivative in nature andpurportedly asserted on behalf of Wave.

On December 22, 2004,Wave moved to dismiss the complaint. The Court held oral arguments on March 25,2005. On September 26, 2005, the Court entered an Order stating that thedefendants’ motion to dismiss has been allowed. On November 22, 2005 theCourt issued a memorandum of decision and entered judgment. The case isterminated in the District Court. However, Plaintiffs have filed a Notice ofAppeal. The appeal is proceeding.

At this time, Wave isunable to predict the outcome of this action.

**(13)**                        IncomeTaxes

The Company did notprovide for any income tax expense or (benefit) for the years ending December 31,2005, 2004 and 2003.

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

| ** **                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory tax  rate            |       |     | 34         | %        |       |     | 34         | % |   |   | 34 | % |   |
| Gain on warrant  liability     |       |     | (1         | )        |       |     | (1         | ) |   |   | — |   |   |
| Change in  valuation allowance |       |     | (33        | )        |       |     | (33        | ) |   |   | (34 | ) |   |
| Total                          |       |     | —     | %        |       |     | —     | % |   |   | — | % |   |

 

Thetax effects of temporary differences that give rise to the deferred tax assetat December 31, 2005 and 2004 are as follows:

| ** **                                   | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|----------------------------------------------|------------|-------------|------------|-------------|------------|
| Deferred tax  assets:                        |       |        |       |        |       |
| Net operating and capital loss carryforwards |       | $           | 91,503,000 |        | $          | 83,980,000 |   |
| Accrued expenses                             |       | 480,000     |       | 403,000     |       |
| Intangibles                                  |       | 534,000     |       | 666,000     |       |
| Reserves                                     |       | 903,000     |       | 1,010,000   |       |
| Depreciation                                 |       | 532,000     |       | 681,000     |       |
| Unrealized losses                            |       | —      |       | 55,000      |       |
| Total gross deferred tax assets              |       | 93,952,000  |       | 86,795,000  |       |
| Less valuation allowance                     |       | (93,952,000 | )          | (86,795,000 | )          |
| Net deferred tax  asset                      |       | $           | —     |        | $          | — |   |

 

F-41

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**(13)        IncomeTaxes (Continued)**

The valuation allowanceincreased by approximately $7.2 million and $7.5 million, during the yearsended December 31, 2005 and 2004, respectively.

Management has concludedthat it is more likely than not that Wave will not have sufficient taxableincome of an appropriate character within the carryback and carryforwardperiods permitted by current law to allow for the utilization of the deferredtax assets and, therefore, a valuation allowance has been established againstthe deferred tax assets of $93,952,000 as of December 31, 2005. Subsequentlyreported tax benefits relating to the valuation allowance for deferred taxassets as of December 31, 2005 will be allocated as follows: $93,137,000to continuing operations and $815,000 to additional paid-in capital for amountsattributable to exercise of employee stock options.

Wave has net operatingloss carryforwards for tax return purposes of approximately $242.7 million,which expire beginning in 2010 through 2025. Wave also has capital losscarryforwards for tax return purposes of approximately $8.6 million, whichexpire beginning in 2008 through 2010. Pursuant to Section 382 of theInternal Revenue Code, the annual utilization of Wave’s net operating andcapital loss carryforwards may be substantially limited if a cumulative changein ownership of more than 50% occurs within any three-year period. Wave has notdetermined whether there have been such cumulative changes in ownership or theimpact on the utilization of the loss carryforwards if such changes haveoccurred. However, in considering Section 382 of the Internal RevenueCode, Wave believes that it is likely that such a change in ownership hasoccurred thus raising the likelihood that such net operating and capital losscarryforwards are subject to annual limitations.

**(14)**                        DefinedContribution Plan

Wave adopted the WaveSystems Corp. 401(k) Savings and Investment Plan, a defined contributionplan, to which substantially all employees can contribute, on January 1,1995. Employees of Wave become eligible immediately on employment. Wave has theoption to make discretionary matching contributions; no contributions were madein 2005, 2004 or 2003.

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

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

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

Fairvalue estimates are made at a specific point in time, based on relevant marketinformation and information about the financial instrument. These estimates aresubjective in nature and involve uncertainties and matters of significantjudgment and therefore cannot be determined with precision. Changes inassumptions could significantly affect the estimates.

**(16)**                        Impairmentof Developed Software

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

F-42

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**(17)**                        RecentAccounting Pronouncements

In December 2004, the Financial Accounting StandardsBoard (“FASB”) issued its final standard on accounting for share-basedpayments, Statement of Financial Accounting Standard No. 123(R)—Share-Based Payment(“SFAS 123(R)”).  SFAS 123(R) requirescompanies to expense the fair value of employee stock options and similarequity compensation, also known as share-based payment (“SBP”) awards.  The statement applies to all outstanding andunvested SBP awards as of a company’s adoption date.  The Securities and Exchange Commissiondelayed implementation of SFAS 123(R) to fiscal years beginning after June 15,2005.  Therefore, we implemented SFAS123(R) effective January 1, 2006 using the modified prospective method, whichrequires the recognition of expense for SBP awards over their remaining vestingperiod.  The portion of these SBPs’ fairvalue attributable to awards that vested prior to the adoption of SFAS 123(R)is never recognized under this method. We estimate that the impact of the adoption of SFAS 123(R), to Wave forthe year ending December 31, 2006, will be an expense of approximately $1.4million, or $0.01 to $0.02 per share. However, our assessment of the estimated compensation charges isdependent upon assumptions regarding a number of complex and subjectivevariables.  These variables include, butare not limited to, the volatility of our stock price, interest rates, thelevel and type of SBPs that Wave awards and employee stock option exercise behaviors.  As such, our actual share-based compensationexpense may differ from this estimated amount.

**(18)**                        SegmentReporting

Wave’s products includethe Wave EMBASSY® digital security products and services and Wavexpressbroadband media distribution products and services. These products and servicesconstitute Wave’s reportable segments under Statement of Financial AccountingStatement No. 131—Disclosures about Segments of an Enterprise and RelatedInformation. Net losses for reportable segments exclude interest income,unrealized gains on decrease in value of warrant liability, liquidated damagesin connection with a private placement of equity securities, recovery of a notereceivable with a former officer, gain on sales of marketable securities andother income. These items are not reported by segment since they are excludedfrom the measurement of segment performance reviewed by Wave’s management.

F-43

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**(18)**                        SegmentReporting (Continued)

Thefollowing sets forth reportable segment data:

| ** **                                                     | ** ** | **For the years ended December 31,** | ** **  |
|----------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                     | ** ** | **2005**                                                      | ** **  | **2004** | ** ** | **2003** | ** ** |
| Operating Revenues:                                            |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services           |       | $                                                             | 976,807     |   | $ | 164,350 |   | $ | 107,635 |   |
| Wavexpress broadband media distribution products and  services |       | 41,657                                                        |        | 44,961 |   | 81,728 |   |
| Total Operating Revenues                                       |       | 1,018,464                                                     |        | 209,311 |   | 189,363 |   |
| Net Loss:                                                      |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services           |       | (15,986,692                                                   | )           | (15,915,487 | ) | (17,224,356 | ) |
| Wavexpress broadband media distribution products and  services |       | (2,219,354                                                    | )           | (3,436,453 | ) | (3,839,292 | ) |
| Total Segments Net Loss                                        |       | (18,206,046                                                   | )           | (19,351,940 | ) | (21,063,648 | ) |
| Interest Income                                                |       | 70,779                                                        |        | 24,931 |   | 74,822 |   |
| Unrealized gain on decrease in value of warrant  liability     |       | 490,334                                                       |        | 498,723 |   | 263,097 |   |
| Liquidated damages in connection with private  placement  |       | —                                                        |        | — |   | (155,716 | ) |
| Recovery of officer note receivable                            |       |                                                          |        |   |   | 999,518 |   |
| Gain on sale of marketable securities                          |       | 80,971                                                        |        | 4,330,248 |   | 234,759 |   |
| Other Income                                                   |       | 1,500                                                         |        | — |   | 52,370 |   |
| Net Loss                                                       |       | $                                                             | (17,562,462 | ) | $ | (14,498,038 | ) | $ | (19,594,798 | ) |
| Depreciation and  Amortization Expense:                        |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services (1)       |       | 746,536                                                       |        | 703,137 |   | 932,869 |   |
| Wavexpress broadband media distribution products and  services |       | 95,193                                                        |        | 151,492 |   | 308,166 |   |
| Total Depreciation Expense                                     |       | $                                                             | 841,729     |   | $ | 854,629 |   | $ | 1,241,035 |   |
| Capital Expenditures:                                          |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services           |       | 152,474                                                       |        | 186,756 |   | 831,147 |   |
| Wavexpress broadband media distribution products and  services |       | 8,355                                                         |        | 117,416 |   | 153,999 |   |
| Total Capital Expenditures                                     |       | $                                                             | 160,829     |   | $ | 304,172 |   | $ | 985,146 |   |
| Assets:                                                        |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services           |       | 3,235,946                                                     |        | 8,167,614 |   | 17,726,026 |   |
| Wavexpress broadband media distribution products and  services |       | 193,819                                                       |        | 286,968 |   | 434,404 |   |
| Total Assets                                                   |       | $                                                             | 3,429,765   |   | $ | 8,454,582 |   | $ | 18,160,430 |   |

 

**(19)**                        SelectedQuarterly Financial Data (unaudited)

| ** **                                        | ** ** | **Quarter-ended**     | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **December 31,** | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| ** **                                        | ** ** | **2005**              | ** ** | **2005** | ** ** | **2005** | ** ** | **2005** | ** ** |
| Revenues                                          |       | $                     | 347,598    |   |   | $ | 335,335 |   |   | $ | 257,655 |   | $ | 77,876 |   |
| Gross Profit                                      |       | 151,663               |       |   | 150,419 |   |   | 80,771 |   | (91,242 | ) |
| Loss from  Operations                             |       | (4,533,151            | )          |   | (4,464,460 | ) |   | (4,526,144 | ) | (4,682,289 | ) |
| Net loss to  common shareholders                  |       | (4,495,149            | )          |   | (4,361,808 | ) |   | (4,159,925 | ) | (4,545,578 | ) |
| Net loss to common  shareholders per Common Share |       | $                     | (0.05      | ) |   | $ | (0.05 | ) |   | $ | (0.05 | ) | $ | (0.06 | ) |

 

F-44

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**(19)**                        SelectedQuarterly Financial Data (unaudited) (Continued)

| ** **                                        | ** ** | **Quarter-ended**     | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **December 31,** | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| ** **                                        | ** ** | **2004**              | ** ** | **2004** | ** ** | **2004** | ** ** | **2004** | ** ** |
| Revenues                                          |       | $                     | 108,193    |   |   | $ | 44,375 |   |   | $ | 6,300 |   | $ | 50,443 |   |
| Gross Profit                                      |       | 21,756                |       |   | 9,334 |   |   | 3,208 |   | 23,309 |   |
| Loss from  Operations                             |       | (4,262,591            | )          |   | (4,602,961 | ) |   | (5,448,637 | ) | (5,037,751 | ) |
| Net loss to  common shareholders                  |       | (2,967,830            | )          |   | (3,800,517 | ) |   | (4,320,927 | ) | (3,408,764 | ) |
| Net loss to common  shareholders per Common Share |       | $                     | (0.04      | ) |   | $ | (0.05 | ) |   | $ | (0.06 | ) | $ | (0.05 | ) |

 

**(20)**                        SubsequentEvent

On February 15, 2006, Wave entered into a securitiespurchase agreement, pursuant to which Wave agreed to sell and issue 8,348,598shares of Class A Common Stock, par value $.01 per share, to certainpurchasers who are parties to the Purchase Agreement (the “Purchasers”) for anaggregate purchase price of $4,466,500. The Common Shares were priced at $0.535per share. The Purchasers were also granted warrants (the “Warrants”) topurchase up to 1,550,868 shares of Class A common stock at an exerciseprice of $0.72. The Warrants are exercisable for a period of six monthsfollowing the date of issuance. Each Warrant is subject to cancellation if theclosing bid price of Wave’s common stock exceeds $0.86 for 10 out of 20consecutive trading days and the Warrant has not been exercised by the close ofbusiness on the trading day after the 10th trading day on which the closing bidprice exceeds $0.86. The Placement Agent had entered into a placement agencyagreement with Wave in which they agreed to act as placement agent inconnection with the offering. Wave has agreed to pay the Placement Agent a feeequal to 4.0% of the gross proceeds of this offering. Wave realized netproceeds of approximately $4,247,840 after deducting the placement agent feesof $218,660 and additional legal and other fees associated with the issuance ofthese securities, which Wave estimates will be approximately $40,000. Thissecurities purchase agreement specifies that the shares shall be issuedpursuant to a shelf registration statement which was filed by Wave on December 16,2005 and declared effective by the Securities and Exchange Commission (the “SEC”)on January 13, 2006.

F-45

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