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


                                    FORM 10-K


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

                   For the fiscal year ended December 31, 1998

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

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

                         Commission File Number 0-24752

                               Wave Systems Corp.
             (Exact name of registrant as specified in its charter)

              Delaware                                          13-3477246
   (State or other jurisdiction of                           (I.R.S. Employer
   incorporation or organization)                           Identification No.)

         480 Pleasant Street
         Lee, Massachusetts                                        01238
(Address of principal executive offices)                        (Zip Code)

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

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

                                      None

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

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

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

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

         The aggregate market value of the shares of Common Stock of the
registrant held by non-affiliates as of March 5, 1999 was $338,387,574 (For
purposes of this calculation, the market value of a share of Class B Common
Stock was assumed to be the same as a share of Class A Common Stock, into which
it is convertible.)

         As of March 5, 1999, there were 29,273,767 shares of the registrant's
Class A Common Stock and 2,770,991 shares of the registrant's Class B Common
Stock outstanding.


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<PAGE>

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



<PAGE>

                                     PART I

Item 1.           Business

Overview

         Wave Systems Corp. ("Wave" or the "Company") is creating a new
electronic commerce model for digital information and services based on
client-side security, transactions and trust. Since its inception in February of
1988, the Company has devoted substantially all of its efforts and resources to
research, feasibility studies, design, development, and market testing of a
distributed trust system that enables client based transactions, including the
metered usage of electronic content and services (the "Wave System"). Electronic
content and services refers to any data, graphic software, video or audio
sequence that can be digitally transmitted and/or stored. As its research and
development activities matured, the Company was able to devote increased
resources to creation of content distribution services, market development and
the application of the Wave System to end-user services.

         The Company believes that the Wave System can fundamentally change
today's centralized e-commerce model by creating a distributed trust and
security system, where transactions are executed and recorded in the consumer's
devices, at the consumer's location. This means that electronic content and
services can be consumed with more efficient and flexible pricing, broader
distribution opportunities, greater protection against unauthorized usage and
secure, low-cost, and accurate data on the usage of the products and services.

         The Wave System consists of an EMBedded Application Security SYstem
                                        ---      -           -        --
("EMBASSY") in consumer devices that provide the basis for a multi-party trusted
system using both hardware and software. The EMBASSY is a programmable, low cost
"system within a system" that can perform independent transactions such as meter
content usage, store sensitive information such as identities and account
balances and run secure applications for access to services. The EMBASSY is an
open system based on secure smart card hardware technology that can be
integrated into PCs, peripherals, set top boxes or used as an independent
component. The WaveMeter application running in the EMBASSY allows transactions
to occur without the expense of a real-time network connection for every
transaction. The EMBASSY securely stores electronic funds and transaction
information about the usage of electronic content to be transmitted securely to
a central transaction processing center ("WaveNet") periodically. WaveNet
manages encryption and decryption keys, processes credit and usage charges,
automatically obtains credit authorization, calculates royalty distributions,
and can provide user and usage data to electronic content owners. The Wave
System is designed to be compatible with every existing content delivery system
such as CD-ROM, the Internet, and digital broadcast. PC OEMs, content providers
and services providers such as telecommunications companies have expressed
interest in the Wave System and the Company believes that once there is a broad
installed base of the EMBASSY, electronic content and service providers from
other market segments are likely to be attracted to the Wave System.

         In order to achieve broad market acceptance of the Wave System, the
Company pursues strategic relationships with major personal computer
manufacturers and technology suppliers, and promotes the use of the EMBASSY to
electronic content owners, particularly developers and distributors of
entertainment, audio, broadcast and educational software. The Company believes
that the EMBASSY can be the foundation for a "client-side subscriber management
system" that is independent of the content or delivery network. This means that
content can be delivered on CD-ROM, data broadcast, broadband and other forms of
transmission.

          The Company believes that the Wave System provides a powerful
merchandising interface for electronic content and services at the point of
purchase. This may increase the interest of consumers to sample electronic
content that they are considering purchasing. The Wave System provides the
consumer with enhanced control of their individual privacy and secure storage of
sensitive information. The Wave System facilitates the payment of royalties to
content providers and service partners while allowing both customized and broad,
inexpensive distribution to customers.

         In 1998, the Company enhanced the Wave System to make it acceptable as
an open industry standard for a broad range of security and e-commerce functions
in end user-devices. Wave has been successful in attracting other companies to
port their applications and services to the Wave System and its EMBASSY
platform, which the Company believes will increase the value of the system to
potential deployment partners. These strategic relationships have generated what
the Company believes to be significant joint marketing benefits in our efforts
to promote the Wave System to OEMs and the content industry.


                                      -2-


<PAGE>

         During 1998 the Company established relationships with RSA Data
Security, NEC Technologies, Inc., Pollex Technology Ltd., Hewlett-Packard
Company's VerSecure division, Sun Microsystems, SMSC, ITE, IGST, Sarnoff Corp.,
Hauppauge Computer Systems and WavePhore. The Company also received a payment of
$4 million pursuant to a joint venture agreement with Internet Technology Group,
PLC ("ITG"), a United Kingdom company.

         In 1999 the Company will seek to continue to expand its commitments
from additional hardware manufacturers, including personal computer
manufacturers, peripheral companies and companies involved in the commerce of
electronic content and services both in North America and overseas. The Company
also seeks to expand the role of the Wave System and EMBASSY as a general
security device in networks in order to provide new opportunities for the
creation of virtual private networks and services by telecommunications vendors
and Internet service providers.

         Additionally, in 1996 the Company developed a production software
version of the WaveMeter application that offers a subset of the features of the
hardware version and has been implemented as part of the Company's Internet
commerce server (the "WaveMeter server"). The WaveMeter server enables content
owners to secure and sell their intellectual property from a web site. The
e-commerce services offered through the Wave Meter server do not require the
consumer or publisher to install any additional hardware or software.

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

         In order to reduce these uncertainties, the Company is currently
evaluating additional financing options and may therefore elect to raise
capital, from time to time, through equity or debt financings in order to
capitalize on business opportunities and market conditions and to insure the
continued development of the Company's technology, products and services. In
January, 1999, the Company issued a convertible promissory note in aggregate
principal amount of $2 million, which was subsequently converted into Class A
common stock in March, 1999, in addition to and following the Company's
completion of an additional $23 million private placement with institutional,
strategic and accredited investors. There can, however, be no assurance that the
Company can raise additional financing in the future.

         As of October 19, 1997, the Company became obligated to redeem for
approximately $465,000 all of the outstanding shares of the Series A Redeemable
Preferred Stock issued to a certain individual pursuant to the terms of the
Restated Certificate of Incorporation. As of December 31, 1998, the Company's
total obligation (principal plus interest) under the Series A redemption was
$493,201, and it continues to accrue dividends and interest. The Company has not
redeemed such shares as of March 30, 1999, nor has any demand for redemption
been made.

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

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

         On January 29, 1999 the Company filed an application with the Listings
Qualifications Panel of the Nasdaq Stock Market, Inc., seeking to list on the
Nasdaq National Market. There can be no assurances that Nasdaq will approve the
application. As of March 30, 1999, Nasdaq has not issued its decision.


                                      -3-


<PAGE>

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

         The Company is a development stage company and has realized minimal
operating revenues since its inception. At December 31, 1998 the Company had an
accumulated deficit of approximately $57.2 million. There can be no assurance
that the Company will be successful in achieving commercial acceptance of the
Wave System.

The Wave System

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

         In addition, the programmable EMBASSY is able to support multiple
secure applications from a range of service providers, applications vendors, and
security companies. The Company seeks to exploit this multi-application
capability to create new sources of revenue through hosting secure applications
and creating additional services based on the EMBASSY distributed trust model.
The Company believes that its expansion of the EMBASSY has provided a source of
increased interest in Wave's technology as a general-purpose solution for
adoption by a wide range of companies in their platforms and as a secure
delivery mechanism.

         The Wave System consists of the EMBASSY E-Commerce System, the
WaveMeter application, a subsystem that records and communicates the usage of
electronic content, and WaveNet, a central transaction processing network. The
EMBASSY controls the loading and execution of multiple secure applications. The
WaveMeter controls and monitors the customer's access to encrypted electronic
information and software. Because the Wave System uses asynchronous
communication, it is well suited to low-cost processing of micro, rental and
rent-to-own transactions. The Company has completed a prototype incorporating
the rental and rent-to-own functionality into the Wave System using Wave's
current chip technology. This is currently being integrated into a WinTV tuner
card from Hauppauge Computer Systems. This product is planned for introduction
into the market in 1999. With this version of the WaveMeter, application
transactions are executed locally against a source of funds stored in the
WaveMeter secure memory. The WaveMeter retains pricing and licensing
information, downloaded from WaveNet, for use in the execution of these
transactions. Transactions are securely stored in the usage log of the WaveMeter
for eventual reporting to WaveNet. The WaveMeters and WaveNet communicate using
Wave's secure communications protocol.

         WaveNet is composed of the WaveNet Transaction Processing System
("TXP") and the WaveNet Information Clearing House ("ICH"). TXP acts as the
principal interface with the EMBASSY. Every EMBASSY-equipped device will contact
TXP on a periodic basis. During this secure communication, all stored event
information, such as purchase logs, are uploaded to TXP, additional credit may
be requested, pending events are delivered to the device, and a routine audit
check is performed. There may be a number of TXP systems to distribute access
around the globe. TXP routes all event logs to ICH where they are processed
against Wave's royalty contracts. ICH calculates royalties due to each partner
and handles the billing and reporting services, ensuring that all Wave partners
are properly compensated. WaveNet is presently in operation.


                                      -4-


<PAGE>

         The Wave System is installed into the customer's PC or integrated into
an attached peripheral device. It is based on a semiconductor device that uses
secure certified integrated circuit technology to store decryption keys, credit
information, and usage data. Presently, the WaveMeter based on Wave's own
silicon chip is packaged on a half-size ISA board with a battery and a clock and
can be installed in the ISA slot of a PC. In 1999 Wave plans to deliver a new
version of the EMBASSY hardware with a Universal Serial Bus interface (USB)
which should easily integrated into a broad range of products including separate
dongles for portable EMBASSY devices. In 1996 the Company also developed a
production software version of the WaveMeter application which has been
implemented as a component of the WaveMeter server. The use of the software
version of the WaveMeter is compatible with the use of the hardware version of
the WaveMeter application.

         The Company believes that the hardware version of the Wave System with
EMBASSY is the most secure form of content licensing management and metering
technology available today. The hardware and software of the EMBASSY contains a
wide range of security features to strengthen the trusted client capabilities in
user devices. Tampering with the EMBASSY or Wave System applications results in
automatically initiated system lockouts, and is readily detected by both the
EMBASSY and WaveNet. The encryption keys are loaded at the time of manufacture
and are unique and specific to each EMBASSY device. Every piece of electronic
content is protected using a unique key. Services are controlled by secure
applications running in the EMBASSY. Wave believes it has designed a security
architecture where the value of breaking an individual system to ascertain the
keys is low since there are no common keys that allow system-wide use.

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

Markets and Business Strategy

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

         The Company has focused on forming agreements with strategic partners
that will help the Company promote the broad-based acceptance of the Wave System
as a platform for commerce in electronic content. Wave is currently in
discussion with original equipment manufacturers regarding the incorporation of
the Wave System and EMBASSY into their products. Wave has also focused on
pursuing strategic relationships with companies seeking to distribute electronic
content via the Internet. The compatibility of the Wave System with the Web has
provided the Company with a product that has already attracted the attention of
leaders in the development of electronic commerce solutions and particularly
commerce in electronic content. Wave will continue to focus on developing other
strategic relationships to seek to achieve the broad acceptance of the Wave
System as a platform for electronic commerce.

         Wave has focused on promoting the acceptance of the Wave System by
electronic content owners. The initial target market is entertainment and
educational software developers and distributors. Wave believes 


                                      -5-


<PAGE>

that the Wave System will provide the home consumer with a new way of acquiring
interactive content and can offer electronic content developers and distributors
benefits similar to those provided by video rental in the film industry. The
Company has invested heavily in developing relationships with entertainment and
educational software providers. Wave today has over 50 titles functional for
demonstration and is actively preparing others to be launched in 1999.

Competition

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

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

         The Wave System is subject to competition from producers of
hardware-based controllers such as dongles and software unlocking systems. The
Company will compete with well-established producers of dongle-based software
unlocking systems such as Rainbow Technologies, Inc. The Company also competes
with developers of software unlocking systems such as Portland Software. Wave
Systems also provides basic security services that compete with companies such
as QPass and PrivaSeek in providing electronic wallets and certain e-commerce
capabilities. The Company believes that the Wave System is superior to existing
hardware-based and software unlocking systems in several ways. These systems
primarily operate as "on/off switches" to control the use of electronic content
and services, but are very limited in their ability to measure and record usage
information. The Company believes that the Wave System offers superior
protection from unauthorized usage, low operating costs (because it does not
require constant communication with and authorization from a centralized
processor), and fast operation that is convenient and essentially transparent to
the end user. Both hardware controllers and software unlocking systems offer
only part of the functionality of the Wave System. Wave Systems distributed
trust model also provides a superior solution for broadcast and multicasting of
data. Distinct from the existing software unlocking systems, WaveNet provides
centralized back-office support to owners of electronic content.

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


                                      -6-


<PAGE>

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

International Market

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

Exportable EMBASSY Systems with Strong Cryptography

         Wave Systems formed a strategic alliance in 1998 with HP VerSecure in
the development of the trusted client architecture that is the basis of the
EMBASSY E-Commerce System. HP VerSecure provides a security management framework
for EMBASSY that controls the cryptography functions of the device and
application uses of encryption. The primary function of the VerSecure system is
to provide a policy management system that enables the EMBASSY hardware to have
strong cryptography features that can be selectively enabled or disabled in
order to comply with various nations' strength-of-cryptography regulations. This
capability is intended to allow PC OEMs to build a single, consistent product
which can be shipped worldwide, regardless of local cryptography restrictions.

Proprietary Rights and Licenses and Intellectual Property

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

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

         The Company holds non-exclusive patent rights relating to the metered
use of encrypted data in local memory under a limited license (the "License
Agreement") from Titan Corporation ("Titan") to a patent (the "Licensed Patent")
jointly held by Titan and a third party. This License Agreement restricts Wave
from metering information produced and used solely by a government entity or
producing products that meter this information. In addition, the License
Agreement is subject to the rights of the joint owner of the Licensed 


                                      -7-


<PAGE>

Patent, who has the right to exploit, or to license to third parties, the
Licensed Patent, including in a manner competitive with the Company. There can
be no assurance that the joint owner of the Licensed Patent will not compete
with the Company or license the Licensed Patent to a competitor of the Company,
or that the Company's business will not exceed the scope of the License
Agreement. Pursuant to the License Agreement, the Company is obligated to pay
certain royalties to Titan. Pursuant to the License Agreement, the Company has
granted to Titan the exclusive right to use the Company's patents for products
distributed to government entities. On February 28, 1997 the Company and Titan
executed an addendum to the License Agreement whereby the Company received a
sole license to the Licensed Patent to develop and distribute products to the
in-home consumer microcomputer market segment. Under this addendum to the
License Agreement, Titan waived any and all defaults by Wave under the License
Agreement occurring prior to February 28, 1997.

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

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

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


                                      -8-


<PAGE>

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

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

         The Company also relies on copyright to prevent the unauthorized
duplication of its software and hardware products. The Company has and will
continue to protect its software and its copyright interest therein through
agreements with its consultants. There can be no assurance that the copyright
laws will adequately protect the Company's technology.

         The Company has registered trademark and service mark registrations
with the United States Patent and Trademark Office for the marks WaveMeter(R)
and WaveNet(R), Great Stuff Network, Second Shift (the Wave juggler logo),
WaveCommerce, Wave Interactive Network, WINPublish, WINPurchase and CablePC. The
Company has submitted trademark registrations for EMBASSY, EMBASSY System and
EMBASSY E-Commerce System and intends to apply for additional name and logo
marks in the United States and foreign jurisdictions as appropriate. No
assurance can be given that federal registration of any of these trademarks in
the United States will be granted. The Company has abandoned its prior
applications for DataWave, InfoWave, and WaveTrac.

Research and Development

         The Wave System incorporates semiconductor, encryption/decryption,
software transaction processing and other technologies in which the Company has
made a substantial investment in research and development. The Company expects
that it will be required to continue to make substantial investments in the
design of the Wave System including EMBASSY, the WaveMeter, WaveNet and software
interfaces. For the years ended December 31, 1998, 1997, and 1996, the Company
expended approximately $3.5 million, $2.1 million and $3.3 million respectively,
on research and development activities (which amounts include the value of stock
issued). In addition to its ongoing research and development activities, in July
1997 the Company licensed technology and in-process research and development
from Aladdin Knowledge Systems for cash and warrants valued at $3.9 million.
From its inception in February 1988 through December 1998, the Company expended
approximately $18.3 million on research and development activities.

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

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

         Wave is now focusing increased resources on developing the operational
infrastructure of the Company. Greater emphasis is placed on developing internal
production and fulfillment systems and marketing infrastructure to distribute
the Wave System. The Company will also increase the resources available to
WaveNet to adapt to 


                                      -9-


<PAGE>

changing market requirements. The Company plans to expand WaveNet to handle more
end users, to implement more sophisticated pricing methodologies and to add
greater financial system flexibility.

Employees

         As of December 31, 1998, the Company employed 80 full-time employees,
38 of whom were involved in sales, marketing and administration and 42 of whom
were involved in research and development. As of December 31, 1998, the Company
employed 9 full-time consultants, which are reflected in the foregoing figures.
The Company believes its employee relations are satisfactory.

Item 2.           Properties

         The Company leases a 10,748 square foot facility for its executive
offices and to house the WaveNet installation, administration, and customer
support operations in Lee, Massachusetts at a monthly rent of $5,598 with a
monthly charge of $2,123 for common costs. The Lee, Massachusetts lease will
expire during February 2001. The Company leases offices in New York, New York,
at a monthly rent of $7,433. The lease is scheduled to expire in June 1999. The
Company leases a 6,400 square foot facility in Princeton, New Jersey at a
monthly base rent of $4,214 with a monthly payment for taxes, insurance and
maintenance reimbursements and improvements which currently totals approximately
$1,653 per month. This lease is scheduled to expire during January 2001. The
Company's principal research and development activities are conducted at the
Princeton facility. The Company leases a 2,728 square foot facility in San Jose,
California for $6,138 per month. The San Jose, California lease will expire
during December 2001.

Item 3.           Legal Proceedings

         Not applicable.

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

         On November 9, 1998, the Company held its Annual Meeting of
shareholders. At the Annual Meeting, the shareholders voted on the following
matters:

         1.       The election of six directors to hold office until the next 
Annual Meeting and until their successors are duly elected and qualified. The
previous board was re-elected with the following results:


<TABLE>
<CAPTION>
DIRECTOR                                FOR                      AGAINST
--------                                ---                      -------

<S>                                       <C>                           <C>    
Peter J. Sprague                          25,150,986                    307,201

John E. Bagalay, Jr.                      25,144,086                    314,101

Philippe Bertin                           24,994,643                    463,544

George Gilder                             25,151,623                    306,364

John E. McConnaughy, Jr.                  25,150,886                    307,301

Steven Sprague                            25,148,686                    309.501
</TABLE>


         2. A proposal to amend the Restated Certificate of Incorporation of the
Company to increase the number of Class A Common Stock that the Company is
authorized to issue from 50 million to 75 million shares. The proposal passed,
with 24,236,103 votes for, 1,079,758 votes against and 151,326 abstentions.

         3. A proposal to amend the Company's 1994 Employee Stock Option Plan to
(i) increase the number of shares of Class A Common Stock reserved for issuance
thereunder by 5,000,000 shares, and (ii) increase the maximum number of shares
of the Company's Class A Common Stock covered by options that may 


                                      -10-


<PAGE>

be granted to any single individual in any fiscal year from 100,000 shares to
500,000 shares. The proposal passed, with 7,859,012 votes for, 1,711,250 votes
against and 375,777 abstentions.

         4. A proposal to amend the Company's 1994 Non-Employee Directors Stock
Option Plan to (i) increase the number of shares of Class A Common Stock
reserved for issuance thereunder by 500,000 shares, and (ii) provide that
options issued to non-employee directors under such plan vest on the day
following the grant. The proposal passed, with 8,696,127 votes for, 1,571,551
votes against and 447,355 abstentions.

         5. A proposal to ratify the appointment of KPMG Peat Marwick LLP as the
Company's independent auditors for the year ending December 31, 1998. The
proposal passed, with 22,532,604 votes for, 44,794 votes against and 502,259
abstentions.


                                     PART II

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

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


<TABLE>
<CAPTION>
                                                                   High             Low
                                                                   ----             ---
<S>                                                                <C>             <C>  
Year Ended December 31, 1998
  First Quarter (January 1, 1998-March 31, 1998)                   $1.68           $0.97
  Second Quarter (April 1, 1998-June 30, 1998)                      4.75            1.56
  Third Quarter (July 1, 1998-September 30, 1998)                   4.56            2.25
  Fourth Quarter (October 1, 1998-December 31, 1998)                5.63            2.44


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


         As of March 5, 1999, there were approximately 394 holders of the
Company's Class A Common Stock. As of such date, there were 57 holders of the
Company's Class B Common Stock.

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

Recent Sales of Unregistered Securities


                                      -11-


<PAGE>

         On March 30, 1999 the Company sold 181,818 shares of its Class A Common
Stock, at a price of $11.00 per share, in satisfaction of the then outstanding
principal amount of $2,000,000 on a note it had issued to Carriage Partners,
LLC.

         On March 23, 1999 the Company sold 2,090,954 shares of it Class A
Common Stock, at a price of $11.00 per share, for an aggregate purchase price of
$23,000,494. The shares were sold to a group of accredited investors pursuant to
Regulation D promulgated under the Act. Pacific Growth Equities, Inc.
acted as sole placement agent for the private placement, receiving a commission
of approximately $1.2 million.

         On January 26, 1999 the Company issued warrants to purchase 275,000
shares of its Class A Common Stock at an exercise price of $4.00 per share,
exercisable until January 26, 2004, (the "Warrants") to one (1) accredited
investor. If, over any sixty (60) consecutive day period, the average of the
averaged daily high and low prices of the Class A Common Stock, as reported by
Bloomberg Information Services, Inc., exceeds seven dollars ($7.00), the Company
may force the conversion of the Warrants. The Warrants were issued as
consideration for a $2,000,000 promissory note, bearing no interest, due January
26, 2002.

         On March 6, 1998 the Company issued 150,000 shares of newly created
Series G Convertible Preferred Stock, par value $.01 ("Series G Convertible
Preferred Stock") at a price of $20 per share, for an aggregate purchase price
of $3,000,000. The shares were sold to one (1) accredited investor pursuant to
Regulation D promulgated under the Act. The Series G Convertible Preferred Stock
is convertible into Class A Common Stock, par value $.01 ("Class A Common
Stock") at an effective conversion price of the lower of (a) $1.12 and (b) 80%
of the average of the five (5) lowest trading prices of the Class A Common Stock
during (x) a day on which the Class A Common Stock is traded on The Nasdaq
National Market or The Nasdaq SmallCap Market or principal national securities
exchange or market on which the Class A Common Stock has been listed, or (y) if
the Class A Common Stock is not listed on The Nasdaq National Market or The
Nasdaq SmallCap Market or any stock exchange or market, a day on which the Class
A Common Stock is traded in the over-the-counter market, as reported by the OTC
Bulletin Board, or (z) if the Class A Common Stock is not quoted on the OTC
Bulletin Board, a day on which the Class A Common Stock is quoted in the
over-the-counter market as reported by the National Quotation Bureau
Incorporated (or any similar organization or agency succeeding its functions of
reporting prices) ("Trading Days"), as reported by Bloomberg Information
Services, Inc. during the ten (10) Trading Days immediately preceding the
Conversion Date, as defined in the Certificate of Designation of the Series G
Convertible Preferred Stock. In addition to the Series G Convertible Preferred
Stock, the Company also issued warrants to purchase a total of 225,000 shares of
Class A Common Stock at an exercise price of $1.38 per share, exerciseable until
October 9, 2002. As of February 18, 1999, all of the shares of the Series G
Convertible Preferred Stock have been converted into Class A Common Stock.

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


                                      -12-


<PAGE>

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

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


                                      -13-


<PAGE>

Item 6.           Selected Financial Data


                          Statement of Operations Data



<PAGE>


<TABLE>
<CAPTION>
                                                                                                            Period from
                                                                                                            February 12,
                                                                                                                1988
                                                                                                            (inception)
                                                                                                              through
                                                      Year ended December 31                                December 31
                         --------------------------------------------------------------------------------   ------------
                              1998             1997            1996            1995             1994            1998
                              ----             ----            ----            ----             ----            ----
<S>                      <C>              <C>                   <C>                         <C>                        
Net Revenues             $     10,193     $     10,712     $     1,458     $      -         $              $     22,363
                         ------------     ------------    ------------    ------------     ------------    ------------
                                                              
Operating expenses:
Selling, general and
 administrative------       9,874,166        7,983,151       5,560,620       4,080,185        2,432,283      37,310,672
Write-off of Goodwill               -          769,886               -               -               -          769,886
Aladdin Technology
 License Expense-----               -        3,889,000               -               -               -        3,889,000
Research and
 development---------       3,508,968        2,146,127       3,309,022       3,324,735        1,761,366      18,254,781
                         ------------     ------------    ------------    ------------     ------------    ------------
                           13,383,134       14,788,164       8,869,642       7,404,920        4,193,649      60,224,339
                         ------------     ------------    ------------    ------------     ------------    ------------
Other income (expense):
Technology License
 Fee-----------------       2,750,000        1,000,000             -               -                -         3,750,000
Technology Warrant Cost    (1,100,000)               -             -               -                -        (1,100,000)
Net interest and other
 income (expense)----       ( 173,003)                         184,369         572,054          (77,852)        331,569
                         ------------     ------------    ------------    ------------     ------------    ------------
                                              (120,342)
Net loss-------------    ( 11,895,944 )    (13,897,794)     (8,683,815)     (6,832,866)      (4,271,501)   ( 57,220,407)
Accrued dividends on 
 preferred stock-----         108,863          809,982         199,614          40,600           39,484       1,243,393
                         ------------     ------------    ------------    ------------     ------------    ------------
Assured incremental
 yield---------------         750,000        1,673,000         670,965            -                -         3,093,965
                         ------------     ------------    ------------    ------------     ------------    ------------
Net loss to common
 stockholders--------    $(12,754,807)    $(16,380,776)    $(9,554,394)    $(6,873,466)     $(4,310,985)   $(61,557,765)
                         =============    =============    ============    ===========      ===========   =============
Weighted average
 number of common
 shares outstanding
 during the period---      29,299,844       20,943,748      14,956,584      13,794,373       10,503,621      11,570,172
Loss per common share
                                $(.44)           $(.78)          $(.64)          $(.50)           $(.41)         $(5.32)
                         =============    =============   ============    ============      ===========    ============
</TABLE>


                                      -14-


<PAGE>

                               Balance Sheet Data 

<TABLE>
<CAPTION>
                                                             Year ended December 31
                              -------------------------------------------------------------------------------------
                                   1998             1997              1996             1995              1994
                                   ----             ----              ----             ----              ----
<S>                            <C>                 <C>             <C>               <C>             <C>          
Working capital                                 
   (deficiency)---------       $  (3,778,895)      $  (669,041)    $  3,197,519      $  5,458,512    $  12,463,502
Total assets------------           2,057,812         1,678,213        6,237,219         7,754,042       13,766,864
Current liabilities-----           4,840,989         1,949,886          937,163         1,210,778          867,145
Long-term liabilities---                   -           522,124          465,500                 -                -
Series A Cumulative
   Redeemable Preferred
   Stock----------------             493,201           471,601          432,334           390,534          349,934
Series B Cumulative
   Convertible Preferred
   Stock----------------                   -                 -          195,520                 -                -
Series C Cumulative
   Convertible Preferred
   Stock----------------                   -                 -        2,647,742                 -                -
Deficit accumulated during
   the development stage
                                 (57,220,407)      (45,324,463)     (31,426,669)      (22,742,854)     (15,909,988)
                                 ------------      ------------     ------------      ------------     ------------
Total stockholders'
   equity (deficiency)--      $   (3,276,378)    $    (743,274)    $  1,558,960     $   6,152,730     $ 12,549,785
                              ===============    ==============    ============     =============     ============
</TABLE>


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

Overview


                  Wave Systems Corp. ("Wave" or the "Company") is creating a new
electronic commerce model for digital information and services based on
client-side security, transactions and trust. Since its inception in February of
1988, the Company has devoted substantially all of its efforts and resources to
research, feasibility studies, design, development, and market testing of a
distributed trust system that enables client based transactions, including the
metered usage of electronic content and services (the "Wave System"). Electronic
content and services refers to any data, graphic software, video or audio
sequence that can be digitally transmitted and/or stored. As its research and
development activities matured, the Company was able to devote increased
resources to creation of content distribution services, market development and
the application of the Wave System to end-user services. During 1998 the Company
established relationships with RSA Data Security, NEC Technologies, Inc., Pollex
Technology Ltd., Hewlett-Packard Company's VerSecure division, Sun Microsystems,
SMSC, ITE, IGST, Sarnoff Corp., Hauppauge Computer Systems and WavePhore. The
Company received payments of $1 million and $4 million pursuant to a joint
venture agreement with Internet Technology Group, PLC ("ITG"), a United Kingdom
company, and has recognized $3.75 million to date as license fees and recorded
the net cost to the Company of $1.1 million for an exchange of warrants between
the Company and ITG for 1,000,000 shares of common stock in each company which
is to occur due to attainment of the final milestones and payment of the final
installment of the license fee. From inception through December 31, 1998, the
Company has realized only minimal


                                      -15-


<PAGE>

operating revenues, and does not anticipate significant revenues in the near
future. There are numerous risks that could adversely affect the Company's
efforts to achieve profitability.

Results of Operations

         Years Ended December 31, 1998 and 1997

         For the years ended December 31, 1998 and December 31, 1997 the Company
had only minimal operating revenues.

         Selling, general and administrative expenses for the year ended
December 31, 1998 were $9,874,166 as compared with $7,983,151 for 1997. The
increase in selling, general and administrative expenses was primarily
attributable to increased headcount, as well as trade-show related expenses.

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

         Research and development expenses for the year ended December 31, 1998
were $3,508,968 as compared with $2,146,127 for 1997. The increase in research
and development expenses is attributable to increased headcount and
consulting-related expenses.

         License fee income for the year ended December 31, 1998 was $2,750,000,
as compared with $1,000,000 for 1997. The $2,750,000 for the year ended December
31, 1998 is before a charge of $1.1 million related to the net cost to the
Company of a warrant it is obligated to issue to ITG as part of the technology
licensing agreement. The $1.1 million charge includes the estimated fair value
of the ITG warrant that the Company will receive as part of the warrant
exchange. The license fee for both 1998 and 1997 were portions of a $5 million
fee paid by ITG to the Company as part of a joint venture agreement under which
ITG receives the right to market the Wave technology in European and Middle
Eastern markets.

         Net interest expense for the year ended December 31, 1998 was $173,003
as compared with net interest expense of $120,342 for 1997. The increase in
interest expense for the year ended December 31, 1998 was primarily attributable
to the restated and amended note for Southeast Interactive Technologies Fund I
(see Note 5), offset by an increase in interest-bearing assets. Interest income
of $55,282 for the year ended December 31, 1997 was attributable to the interest
earned on marketable securities purchased with proceeds from the issuance of
convertible preferred stock of the Company in May 1996. The Company held no
marketable securities at December 31, 1998.

         Due to the reasons set forth above, the Company's net loss was
$11,895,944 for the year ended December 31, 1998, as compared with $13,897,794
for 1997.


         Years Ended December 31, 1997 and 1996

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

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

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


                                      -16-


<PAGE>

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

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

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

         Due to the reasons set forth above, the Company's net loss was
$13,897,794 for the year ended December 31, 1997, as compared with $8,683,815
for 1996.

         Liquidity and Capital Resources

         The Company has experienced net losses and negative cash flow from
operations since its inception, and, as of December 31, 1998 had a deficit
accumulated during the development stage of approximately $57.2 million. The
Company has financed its operations through December 31, 1998 principally
through the private placement of Class B Common Stock for an aggregate amount of
$6,201,931 (before deduction of expenses incurred in connection therewith), the
issuance of $2,873,250 in aggregate principal amount of its 10% Convertible
Notes and 15% Notes (of which $2,098,250 was converted into Class B Common
Stock), the sale of 3,728,200 shares of its Class A Common Stock in an initial
public offering raising approximately $15,711,000 after all expenses, the
private placement of 800,000 shares of Class A Common Stock and warrants raising
$800,000 (before deduction of expenses incurred in connection therewith), and
the private placements of convertible preferred stock for an aggregate amount of
$13,350,000 (before deduction of expenses incurred in connection therewith). In
addition, the Company has attempted to reduce cash flow requirements by
compensating key employees, consultants, suppliers and other vendors with Common
Stock and options to purchase Common Stock.

         At December 31, 1998, the Company had approximately $1.1 million in
cash and cash equivalents. The Company held no marketable securities at December
31, 1998. At December 31, 1997, the Company had approximately $759,000 in cash
and cash equivalents. The Company held no marketable securities at December 31,
1997. The increase in cash and cash equivalents is attributable to cash proceeds
of approximately $2.8 million from the issuance of Series G Convertible
Preferred Stock, the last two licensing payments of $750,000 and $3.25 million
from ITG, and Aladdin Knowledge System's exercise of its warrant for 1 million
shares for $2.55 million, less cash used for operating expenses. At December 31,
1998, the Company had working capital deficiency of approximately $3.8 million.
In January, 1999 the Company issued a convertible promissory note in aggregate
principal amount of $2 million, which was subsequently converted into Class A
common stock in March, 1999, following the Company's completion of an additional
$23 million private placement with institutional, strategic and accredited
investors.


         The Company expects to incur substantial additional expenses resulting
in significant 


                                      -17-


<PAGE>

losses at least through the period ending December 31, 1999 due to minimal
revenues associated with initial market entry, continued research and
development costs as well as increased sales and marketing expenses associated
with market testing and roll-out. However, considering the funds received from
the latest common stock offering and the Company's projected operating cash
requirements, the Company anticipates that its existing capital resources will
be adequate to satisfy its capital requirements through the end of the third
quarter of 2000.

         However, as the Company has not yet attained commercial acceptance of
its products and has not yet generated any significant operating revenue,
considerable uncertainty currently exists with respect to the adequacy of
current funds to support the Company's activities. This uncertainty will
continue until a positive cash flow from operations can be achieved.
Additionally, the Company is uncertain as to the availability of financing from
other sources to fund any cash deficiencies.

         In order to reduce this uncertainty, the Company continues to 
evaluate additional financing options and may therefore elect to raise capital,
from time to time, through equity or debt financings in order to capitalize on
business opportunities and market conditions and to insure the continued
development of the Company's technology, products and services. There can,
however, be no assurance that the Company can raise additional financing in the
future.

         The Company presently has no material commitments for capital
expenditures.

         As of December 31, 1998, the Company had available net operating loss
carryforwards for Federal income tax purposes of approximately $47.6 million.
Because of the "change in ownership" provisions of the Tax Reform Act of 1986,
the Company's net operating loss carryforwards may be subject to an annual
limitation on the utilization of these carryforwards against taxable income in
future periods if a cumulative change in ownership of more than 50 percent of
the Company occurs within any three-year period. The Company has made no
determination concerning whether there has been such a cumulative change in
ownership. However, the Company believes that it is likely that such a change in
ownership occurred prior to or following the completion of its initial public
offering.

Recent Accounting Pronouncements

         In June 1997, the FASB issued SFAS 130, "Reporting Comprehensive
Income," which establishes standards for reporting and display of comprehensive
income and its components in a full set of general-purpose financial statements.
Under this concept, all revenues, expenses, gains and losses recognized during
the period are included in income, regardless of whether they are considered to
be results of operations of the period. SFAS 130, which the Company adopted
effective January 1, 1998, did not impact the consolidated financial statements
of the Company.

         In June 1997, the FASB issued SFAS 131, "Disclosures about Segments of
an Enterprise and Related Information," which establishes standards for the way
that public business enterprises report selected information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports to shareholders. It also establishes standards for related disclosures
about products and services, geographic areas and major customers. SFAS 131,
which the Company adopted effective January 1, 1998, did not impact the
Company's consolidated financial statements and footnote disclosures, as the
Company operates in one segment

         The Financial Accounting Standards Board ("FASB") recently issued
Statement of Financial Standards Number 133 ("SFAS 133"), "Accounting for
Derivative Instruments and Hedging Activities." This statement establishes
accounting and reporting standards for derivative instruments and hedging,
requiring recognition of all derivatives as either assets or liabilities in the
statement of financial position measured at fair value. This statement is
effective for all fiscal quarters of fiscal years beginning after June 15, 1999.
The effects of adopting SFAS 133 is not expected to have a material impact on
the Company's financial condition, results of operations or cash flows.

         The AICPA Accounting Standards Executive Committee recently issued
Statement of Position ("SOP")98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use. This 


                                      -18-


<PAGE>

statement requires that certain costs related to the development or purchase of
internal-use software be capitalized and amortized over the estimated useful
life of the software, and is effective for fiscal years beginning after December
15, 1998. The statement also requires that costs related to the preliminary
project stage and post implementation/operations stage in an internal-use
computer software development project can be expensed as incurred. The Company
will comply with the provisions of SOP 98-1 in fiscal 1999. The adoption of this
SOP is not expected to have a material impact on the Company's financial
position or results of operations.

         The AICPA Accounting Standards Executive Committee recently issued SOP
98-5, Reporting on the Costs of Start-Up Activities. This Statement requires
that costs incurred during start-up activities, including organization costs, be
expensed as incurred, and is effective for fiscal years beginning after December
15, 1998. The Company will comply with the provisions of SOP 98-5 in fiscal
1999. The adoption of this SOP is expected to have no impact on the Company's
financial position or results of operations.

Impact of Year 2000 Issue

         The Year 2000 issue results from computer programs written using two
digits rather than four to define the applicable year. Any of the Company's
computer programs that have date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, send invoices or
engage in similar normal business activities.

         The Company made an assessment, with regard to whether its own internal
information systems are Year 2000 compliant. Since January 1998, in addition to
updating employee computers and workstations, the Company has upgraded various
accounting, telecommunications, customer care systems and transaction systems at
an aggregate cost of approximately $400,000, with systems that are warranted by
the vendors to be Year 2000 compliant. To the extent the Company purchases
additional systems, the Company requires that such systems are warranted by the
vendors to be Year 2000 compliant. The Company continues to seek assurances from
its existing vendors whose systems are not warranted to be Year 2000 compliant
that such systems will be Year 2000 compliant. The Company employs a manager of
management information systems, whose responsibilities include oversight of Year
2000 compliance. The Company does not separately track the internal costs
incurred for Year 2000 projects, which are principally the related payroll costs
for its information systems personnel. Although the Company does not believe
that any additional Year 2000 compliance-related costs will be significant,
there can be no assurance that costs incurred to address unanticipated issues
would not have a material adverse effect on the Company's business, operating
results and financial conditions. Any failure of third-party equipment or
software comprising any part of the Company's systems to operate properly with
regard to Year 2000 and thereafter could require the Company to incur
unanticipated expenses to address associated problems, which could have a
material adverse effect on the Company's business, operating results and
financial condition.

         The Company believes, based on an internal assessment, that the current
versions of its software products are Year 2000 compliant. The Company has no
plan to ascertain whether the internal systems and products of its potential
future customers are Year 2000 compliant. The Company may in the future be
subject to claims based on Year 2000 problems in others' products or issues
arising from the integration of multiple products within an overall system.
Although the Company has not been involved in any litigation or proceeding to
date involving its products or services related to Year 2000 issues, there can
be no assurance that the Company will not in the future be required to defend
its products or services or to negotiate resolutions of claims based on Year
2000 issues. The costs of defending and resolving Year 2000-related disputes,
and any liabilities of the Company for Year 2000-related damages, including
consequential damages, could have a material adverse effect on the Company's
business, operating results and financial condition.

         The Company does not have any specific contingency plans if any Year
2000 problems develop with respect to the Company's embedded systems or systems
acquired from vendors. Contingency plans will be developed if the Company
identifies instances of non-compliance and such


                                      -19-


<PAGE>

noncompliance is expected to have a material adverse impact on the Company's
operations. The cost of developing and implementing such plans may itself be
material.

         Year 2000 issues may affect the purchasing patterns of customers and
potential customers in a variety of ways. Many companies are expending
significant resources to replace or remedy their current hardware and software
systems for Year 2000 compliance. These expenditures may result in reduced funds
available to purchase products such as those offered by the Company. The Company
does not believe that there is any practical way to ascertain the extent of, and
has no plan to address problems associated with such a reduction in purchasing
resources of its customers. Any such reduction could, however, result in a
material adverse effect on the Company's business, operating results and
financial condition. The Year 2000 problem is pervasive and complex, as
virtually every computer operation will be affected in some way. Consequently,
no assurance can be given that Year 2000 compliance can be achieved without
significant additional costs.


Item 7A.          Quantitative and Qualitative Disclosure about Market Risk

         Not applicable.


Item 8.           Financial Statements and Supplementary Data

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

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

         Not Applicable.


                                      -20-


<PAGE>

                                    PART III


Item 10.          Directors and Executive Officers of the Registrant


Directors of the Registrant

<TABLE>
<CAPTION>
                                               Business Experience and Principal Occupation or
                                             Employment During Past 5 Years; Positions held with    Director
Name                           Age                      Company; Other Directorships                  Since
----                           ---         -------------------------------------------------------  --------
<S>                            <C>         <C>                                                        <C> 
Peter J. Sprague(1)(4)         59          Chairman of the Company since 1988 and Chief Executive     1988
                                           Officer of the Company since July 1991; Chairman of    
                                           National Semiconductor Corporation from 1965 until May 
                                           1995; Director of EnLighten Software, Inc. and Imagek, 
                                           Inc.; Trustee of the Strang Clinic; Member of Academy  
                                           of Distinguished Entrepreneurs, Babson College.        
                                           
John E. Bagalay, Jr.,          65          Senior Advisor to Chancellor, Boston University from       1993
Ph.D.(1)(2)(4)                             January 1998; Managing Director of Community Technology 
                                           Fund, a venture capital affiliate of Boston University, 
                                           from September 1989 until January 1, 1998; Chief        
                                           Operating Officer, Chief Financial Officer and Director 
                                           of Eurus Technologies, inc. since January 15, 1999;     
                                           General Counsel of Lower Colorado River Authority from  
                                           October 1984 to September 1988; former General Counsel  
                                           of Texas Commerce Bancshares, Inc. and Houston First    
                                           Financial Group; Director of Seragen, Inc., Cytogen,    
                                           Inc., AES, Inc. and several privately-held              
                                           corporations; President and CEO of Cytogen Corporation  
                                           from January 1998, CFO since October 1997; Managing     
                                           Director of Boston University Venture Capital Fund from 
                                           1989-1997.                                              
                                           
Philippe Bertin(3)             49          Manager of Financiere Wagram Poncelet (direct marketing;   1993
                                           media) since December 1991; Manager of Midial S.A.      
                                           (consumer goods) from 1984 until 1991; Manager of       
                                           FINOVELEC since October 1997.                           
                                           
George Gilder(4)               59          Chairman of the Executive Committee of the Company since   1993
                                           1996; Senior Fellow at the Discovery Institute in        
                                           Seattle, Washington; author of nine books, including     
                                           Life After Television, Microcosm, The Spirit of          
                                           Enterprise and Wealth and Poverty; contributing editor   
                                           to Forbes Magazine; Director and President of Gilder     
                                           Technology Group, Inc. (publisher of monthly technology  
                                           reports); former chairman of the Lehrman Institute       
                                           Economic Roundtable; former Program Director for the     
                                           Manhattan Institute; recipient of White House award for  
                                           Entrepreneurial Excellence from President Reagan.        
                                           

John E. McConnaughy,           69          Chairman and Chief Executive Officer of JEMC Corporation   1988
Jr. (1)(2)(3)(4)                           (private investments); Chairman and Chief Executive      
                                           Officer of Peabody International Corporation (an         
                                           environmental services company) from 1969 through 1985;  
                                           Chairman and Chief Executive Officer of GEO              
                                           International Corporation (a nondestructive testing,     
                                           screen printing and oil field services company which was 
                                           spun off from                                            


                                      -21-


<PAGE>


                                           Peabody) from February 1981 to October 1992; Director of 
                                           Riddell Sports Inc., Levcor International, Inc.,         
                                           Transact International, Inc., De-Vlieg Bullard, Inc. and 
                                           Mego Financial Corp. Mr. McConnaughy is also a member of 
                                           the Board of Trustees of the Strang Clinic and the       
                                           Chairman of the Board of the Harlem School of the Arts.  

Steven Sprague                 34          President and Chief Operating Officer of the Company       1997
                                           since May 1996; President of Wave Interactive Network    
                                           from June 1995 to December 30, 1996; Vice President of   
                                           Operations of the Company from April 1994 to June 1995;  
                                           employee of the Company in the areas of operations and   
                                           strategic planning from November 1992 to April 1994;     
                                           consultant to the Company from March 1992 to November    
                                           1992; President of Tech Support, Incorporated (hardware  
                                           technical support information on CD-ROM) from June 1992  
                                           to November 1992; sole proprietor of SKS Environmental   
                                           Sales (manufacturers' representative for water treatment 
                                           companies) from June 1991 to November 1992.              
</TABLE>

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

Involvement in Certain Legal Proceedings

         Mr. McConnaughy is the Chairman of the Board of the Excellence Group,
LLC, which filed a petition for bankruptcy under Chapter 11 on January 13, 1999.
The Excellence Group's subsidiaries produced labels for a variety of customers.

Executive Officers of the Registrant

         The executive officers of the Company are Mr. Peter J. Sprague,
Chairman and Chief Executive Officer, Mr. Steven Sprague, President and Chief
Operating Officer and Mr. Gerard T. Feeney, Senior Vice President of Finance and
Administration, Chief Financial Officer and Secretary.

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

Section 16(a) Beneficial Ownership Reporting Compliance

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

         Based solely upon a review of the copies of such forms furnished to the
Company and, in certain cases, written representations that no Form 5 filings
were required, the Company believes that, with respect to the 1998 fiscal year,
all required Section 16(a) filings were made, except that Mr. Gerard T.
Feeney filed his Forms 3 and 5 late.


                                      -22-


<PAGE>

Item 11.          Executive Compensation

         Summary Compensation Table

         The following table sets forth information with respect to the
compensation paid or awarded by the Company to the Chief Executive Officer and
the other executive officers whose cash compensation exceeded $100,000.
(collectively, the "Named Executive Officers") for services rendered in all
capacities during 1996, 1997 and 1998.

<TABLE>
<CAPTION>
                                                                                                  Long-Term
                                                                                             Compensation Awards
                                                                                             -------------------
                                                       Annual Compensation                    Number of Shares
                                                       -------------------                    
Name and Principal Position             Year         Salary($)         Bonus($)              Underlying Options(#)
---------------------------             ----         ---------         --------              ---------------------
<S>                                     <C>         <C>               <C>                           <C>    
Peter J. Sprague(1)                     1998        $ 182,917         $ 150,000                     895,395
   Chairman and Chief                   1997        $ 160,000         $ 100,000                      10,000
   Executive Officer                    1996        $ 160,000         $  50,000                       -0-
                                                                                                   
Steven Sprague(2)                       1998        $ 177,500         $ 150,000                     954,505
   President and                        1997        $ 150,000         $ 117,500                       -0-
   Chief Operating Officer              1996        $ 131,666         $     -0-                     150,000
                                                                                                   
Gerard T. Feeney(3)                     1998        $  90,359                                       450,000
   Senior Vice President, Chief                                       $  65,000                  
   Financial Officer and                                             
  Secretary
</TABLE>


-------------------
(1) Mr. Peter Sprague received a bonus of $150,000 for 1998; $75,000 was
    received in cash and $75,000 was applied to reduce his debt to the Company
    (see Item 13).

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

(3) Mr. Gerard T. Feeney was hired as Senior Vice President, Finance and
    Administration and Chief Financial Officer on June 8, 1998 and was elected
    Secretary on February 25, 1999.

         Option Grants Table

         The following table sets forth certain information regarding options
granted during the fiscal year ended December 31, 1998 by the Company to the
Named Executive Officers.

<TABLE>
<CAPTION>  
                                                                                     Potential Realizable Value
                           Number of      % of Total                                 at Assumed Annual Rates of
                            Shares         Options                                  Stock Price Appreciation For
                          Underlying     Granted to      Exercise                          Option Term (1)
                           Options        Employees       Price      Expiration     -----------------------------
Name                      Granted (#)    Fiscal Year    ($/Share)       Date          5% ($)          10% ($)
----                      -----------    -----------    ---------   ------------      ------          -------
<S>                         <C>              <C>         <C>           <C> <C>        <C>            <C>    
Peter J. Sprague (2)        300,000          5.7%        $ 1.15        2/6/08         216,900        548,400
                             50,005          0.1           1.10       3/11/08          37,854         74,657
                            545,500         10.4           3.66       5/20/08       1,990,529      4,347,090
Steven Sprague (3)          193,200          3.7           1.15        2/6/08         139,684        353,170
                            250,005          4.8           1.10       3/11/98         189,254        373,257
                            511,300          9.7           3.66       5/20/08       1,865,734      4,074,550
Gerard T. Feeney            450,000          8.6           3.50        6/8/08       1,265,400      2,941,200
</TABLE>
-------------------


                                      -23-


<PAGE>

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

(2)  Includes an aggregate of 300,000 options repriced on February 6, 1998.

(3)  Includes an aggregate of 193,200 options repriced on February 6, 1998.



         Fiscal Year End Option Value Table

         The following table sets forth information regarding the aggregate
number and value of options held by the Named Executive Officers as at December
31, 1998, and the aggregate number and value of options exercised by the Named
Executive Officers during 1998.

<TABLE>
<CAPTION>
                                                               Number of Shares                   Value of Unexercised
                       Shares Acquired                   Underlying Unexercised Options            In-The-Money Options
                         on Exercise    Value Received      at December 31, 1998(#)             at December 31, 1998($)(1)   
                         -----------    --------------   ------------------------------       ------------------------------   
Name                                                     Exercisable       Unexercisable       Exercisable     Unexercisable
----                                                     -----------       -------------       -----------     -------------
<S>                          <C>            <C>             <C>               <C>              <C>             <C>             
Peter J. Sprague             - 0 -          - 0 -           31,995            895,505          $ 67 ,715       $  933,848
Steven Sprague               - 0 -          - 0 -            1,995            954,505              5,245        1,181,261
Gerard T. Feeney             - 0 -          - 0 -            - 0 -            450,000               - 0 -          98,550
</TABLE>                                                                     

-------------------

(1)      The last reported bid price for the Company's Class A Common Stock on 
the OTC Bulletin Board on December 31, 1998 was $3.719 per share. Value is
calculated on the basis of the difference between the respective option exercise
prices and $3.719, multiplied by the number of shares of common stock underlying
the respective options.

         Compensation of Directors

         Directors presently receive no cash compensation for serving on the
Board of Directors. Under the Company's Non-Employee Directors Stock Option
Plan, each director who is not an employee of the Company receives an annual
grant of options to purchase 20,000 shares of Class A Common Stock at fair
market value. The options are granted upon re-election after the annual meeting
of the stockholders and vest the day following the grant. Options terminate upon
the earliest to occur of (i) subject to (ii) below, three months after the
optionee ceases to be a director of the Company, (ii) one year after the death
or disability of the optionee, and (iii) ten years after the date of grant. If
there is a change of control of the Company, all outstanding stock options will
become immediately exercisable.

Item 12.          Security Ownership of Certain Beneficial Owners and Management

         The following table sets forth certain information concerning the
beneficial ownership of the Company's Class A and Class B Common Stock as of
March 5, 1999 (except as otherwise noted) by (i) each stockholder who is known
by the Company to own beneficially more than five percent of the outstanding
Class A or Class B Common Stock, (ii) each director of the Company, (iii) each
of the executive officers of the Company named in the Summary Compensation Table
above, and (iv) all directors and executive officers of the Company as a group.
Holders of Class A Common Stock are entitled to one vote per share on all
matters submitted to a vote of the stockholders of the Company. Holders of Class
B Common Stock are entitled to one vote per share on all matters submitted to a
vote of the stockholders, except that holders of Class B Common Stock will have
five votes per share in cases where one or more directors are nominated for
election by persons other than the Company's Board of Directors and where there
is a vote on any merger, consolidation or other similar transaction which is not
recommended by the Company's Board of Directors. In addition, holders of Class B
Common Stock will have five votes per share on all matters submitted to a vote
of the stockholders in the event that any person or group of persons acquires
beneficial ownership of 20% or more of the outstanding voting securities of the
Company. Shares of Class B Common Stock are convertible into shares of Class A
Common Stock on a one-for-one basis at the option of the holder.


                                      -24-


<PAGE>

<TABLE>
<CAPTION>
                                                                                                     Percent
                                                                                                     of All
                                    Number of Shares                Number of Shares    Percent    Outstanding
                                   of Class A Common  Percent of   of Class B Common      of         Common
Beneficial Owner(1)                  Stock Owned(2)      Class        Stock Owned        Class       Stock(3)
-------------------                -----------------  ----------   -----------------    -------    -----------
<S>                                    <C>                <C>          <C>                <C>          <C>
Peter J. Sprague(4)                    364,486            1.2          1,372,899          49.5         5.4
Steven Sprague(5)                      332,163            1.1            189,659           6.8         1.6
John E. Bagalay, Jr.(6)                 38,000             *                   0           *           *
Philippe Bertin(7)                      38,000             *                   0           *           *
George Gilder(8)                        67,333             *               2,000           *           *
John E. McConnaughy, Jr.(9)             38,000             *             335,000          12.1         1.5
Aladdin Knowledge Sys. (10)          2,531,307            8.0                  0           *           7.3
Gerard T. Feeney                             0             *                   0           *           *
All executive officers and
directors as a group
(7 persons)(11)                        877,982            2.9          1,899,558          68.6         8.5
</TABLE>

-------------------
*Less than one percent.

(1)  Each individual or entity has sole voting and investment power, except as
     otherwise indicated. 
(2)  Does not include shares of Class A Common Stock issuable upon the
     conversion of Class B Common Stock.
(3)  In circumstances where the Class B Common Stock has five votes per share,
     the percentages of total voting power would be as follows: Peter J.
     Sprague, 16.8%; Steven Sprague, 3.0%; John E. Bagalay, Jr., less than 1%;
     Philippe Bertin, less than 1%; George Gilder, less than 1%; John E.
     McConnaughy, Jr., 4.0%; Aladdin Knowledge Systems, 5.9%; and all Executive
     Officers and Directors as a group, 24.1%. 
(4)  Includes 330,496 shares which are subject to options presently exercisable
     or exercisable within 60 days. Also includes 320,000 shares held in trust
     for the benefit of Mr. Sprague's adult children, and for which Mr. Sprague
     is a trustee.
(5)  Includes 320,163 shares which are subject to options presently exercisable
     or exercisable within 60 days. Also includes 37,102 shares held in trust
     for the benefit of Mr. Sprague's family, and for which Mr. Sprague is a
     trustee. 
(6)  Includes 34,000 shares which are subject to options presently exercisable
     or exercisable within 60 days.
(7)  Includes 34,000 shares which are subject to options presently exercisable
     or exercisable within 60 days.
(8)  Includes 67,333 shares which are subject to options presently exercisable
     or exercisable within 60 days.
(9)  Includes 34,000 shares which are subject to options presently exercisable
     or exercisable within 60 days.
(10) Includes 2,531,307 shares which are subject to warrants presently
     exercisable or exercisable within 60 days.
(11) Includes 681,043 shares which are subject to options presently exercisable
     or exercisable within 60 days.


Item 13.          Certain Relationships and Related Transactions

Note Receivable from Director/Officer

         On November 16, 1992, the Company made a personal loan to Mr. Peter J.
Sprague, Chairman and Chief Executive Officer of the Company, as evidenced by a
note for $150,000, which sum was due and payable to the Company on January 16,
1993 and which bore interest at the rate of ten percent (10%) per annum. On the
due date, the note was canceled and the total amount owed was "rolled-over" into
a subsequent note, dated May 12, 1993 for $150,000, plus accrued interest. The
note is due on demand by the Company and accrues interest at the rate of 10% per
annum. On April 22, 1993, the Company made an additional loan to Mr. Peter
Sprague for $23,175 as evidenced by a subsequent note, which is due on demand by
the Company and which bears interest at a rate of 10% per annum. All of these
loans were made to Mr. Sprague for personal reasons. As part of Mr. Sprague's
$150,000 bonus for 1998, $75,000 was applied against his indebtedness to the
Company. As of December 31, 1998, Mr. Sprague's aggregate indebtedness
(including accrued interest) to the Company under the notes totaled $149,342. No
demand has been made as of the date hereof. The notes are secured by a pledge of
67,000 shares of Class B Common Stock.


                                      -25-


<PAGE>

Compensation to Steven Sprague

         Steven Sprague received aggregate compensation of $327,500, $267,500
and $131,666 for services rendered to the Company in 1998, 1997 and 1996,
respectively. Steven Sprague is the son of Mr. Peter J. Sprague, the Chairman
and Chief Executive Officer of the Company.

Compensation to Michael Sprague

         Michael Sprague received aggregate compensation of $112,500 and $27,500
for services rendered to the Company in 1998 and 1997, respectively. Michael
Sprague is the son of Mr. Peter J. Sprague, the Chairman and Chief Executive
Officer of the Company.

Amended and Restated License Agreement and Assignment

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

License and Cross-License Agreement

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


                                      -26-


<PAGE>

                                     PART IV

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

(a) (1) Financial Statements:

                           Consolidated Financial Statements
                           December 31, 1998 and 1997
                           (With Independent Auditors' Report Thereon)
<TABLE>
<CAPTION>
                                                                                             Page(s)
                                                                                              
<S>                                                                                           <C>
Index to Consolidated Financial Statements                                                     F-1
Independent Auditors' Report                                                                   F-2
Consolidated Balance Sheets as of December 31, 1998 and 1997                                   F-3
Consolidated Statements of Operations for each of the years
   ended December 31, 1998, 1997 and 1996 and
   for the period from February 12, 1988 (inception) through December 31, 1998                 F-4
Consolidated Statements of Stockholders' Equity (Deficiency) for
   each of the years ended December 31, 1998, 1997 and 1996 and
   for the period from February 12, 1988 (inception) through December 31, 1998
F-5 Consolidated Statements of Cash Flows for each of the years ended
   December 31, 1998, 1997 and 1996 and for the period from
   February 12, 1988 (inception) through December 31, 1998                                    F-10
Notes to Consolidated Financial Statements                                                    F-12
</TABLE>


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


(a) (3)  Exhibits:


<TABLE>
<CAPTION>
Exhibit No.                                          Description of Exhibit                                                        
------------------------------------------------------------------------------------------------------------------------------------
<S>      <C>           <C>      <C>       
         3.1           --       Restated Certificate of Incorporation of Registrant (incorporated by reference to Exhibit 3.1 of    
                                the Registrant's Registration Statement on Form S-1, File No. 33-75286)                             
         3.2           --       Bylaws of Registrant (incorporated by reference to Exhibit 3.2 of the Registrant's Registration     
                                Statement on Form S-1, File No. 33-75286)                                                           
         4.1           --       Form of Stock Certificate of Class A Common Stock (incorporated by reference to Exhibit 4.1 of the  
                                Registrant's Registration Statement on Form S-1, File No. 33-75286)                                 
         4.2           --       Form of Representative's Warrant Agreement, including the form of Representative's Warrant          
                                (incorporated by reference to Exhibit 4.2 of the Registrant's Registration Statement on Form S-1,   
                                File No. 33-75286)                                                                                  
         4.3           --       Certificate of Designation of Series B Preferred Stock of Wave Systems Corp. as filed with the      
                                Delaware Secretary of State on May 24, 1996 (incorporated by reference to Exhibit 3.1 of the        
                                Registrant's Current Report on Form 8-K filed on May 30, 1996, File No. 0-24752)                    
         4.4           --       Certificate of Designation of Series C Convertible Preferred Stock of Wave Systems Corp. as filed   
                                with the Delaware Secretary of State on December 27, 1996 (incorporated by reference to Exhibit 3.1 
                                of the Registrant's Current Report on Form 8-K filed on January 8, 1997, File No. 0-24752)          
         4.5           --       Certificate of Designation of Series D Convertible Preferred Stock of Wave Systems Corp. as filed   
                                with the Delaware Secretary of State on December 27, 1996 (incorporated by reference to Exhibit 3.1 
                                of the Registrant's Current Report on Form 8-K filed on June 3, 1997, File No. 0-24752)             


                                  -27-


<PAGE>

         4.6           --       Certificate of Designation of Series F Convertible Preferred Stock of Wave Systems Corp. as filed  
                                with the Delaware Secretary of State on October 9, 1997 (incorporated by reference to Exhibit 3.1  
                                of the Registrant's Current Report on Form 8-K filed on October 15, 1997, File No. 0-24752)        
         4.7           --       Certificate of Designation of Series G Convertible Preferred Stock of Wave Systems Corp. as filed  
                                with the Delaware Secretary of State on March 5, 1998 (incorporated by reference to Exhibit 3.1 of 
                                the Registrant's Current Report on Form 8-K filed on March 19, 1998, File No. 0-24752)             
         +10.1         --       Joint Technology Development Agreement, dated as of May 1, 1992, between The Titan Corporation and 
                                Cryptologics International, Inc. (incorporated by reference to Exhibit 10.2 of the Registrant's    
                                Registration Statement on Form S-1, File No. 33-75286)                                             
         +10.2         --       License and Cross-License Agreement, dated as of May 1, 1992, between The Titan Corporation and    
                                Cryptologics International, Inc. (incorporated by reference to Exhibit 10.3 of the Registrant's    
                                Registration Statement on Form S-1, File No. 33-75286)                                             
         10.3          --       Amendment to License and Cross-License Agreement, dated as of August 27, 1993, between The Titan   
                                Corporation and Wave Systems Corp. (incorporated by reference to Exhibit 10.4 of the Registrant's  
                                Registration Statement on Form S-1, File No. 33-75286)                                             
         10.4          --       Amended and Restated License Agreement, dated February 14, 1994, by and among Wave Systems Corp.,  
                                Peter J. Sprague and John R. Michener (incorporated by reference to Exhibit 10.5 of the            
                                Registrant's Registration Statement on Form S-1, File No. 33-75286)                                
         +10.5         --       Wave Systems Corp. 1994 Stock Option Plan (incorporated by reference to Exhibit 10.6 of the        
                                Registrant's Registration Statement on Form S-1, File No. 33-75286)                                
         +10.6         --       Wave Systems Corp. Non-Employee Directors Stock Option Plan (incorporated by reference to Exhibit  
                                10.7 of the Registrant's Registration Statement on Form S-1, File No. 33-75286)                    
         10.7          --       Regulation S Securities Subscription Agreement, dated as of May 29, 1996 (incorporated by reference
                                to Exhibit 4.1 of the Registrant's Current Report on Form 8-K filed on May 30, 1996, File No.      
                                0-24752)                                                           
         10.8          --       Purchase Agreement between Wave Systems Corp. and JNC Opportunity Fund Ltd., dated as of December  
                                27, 1996 (incorporated by reference to Exhibit 4.1 of the Registrant's Current Report on Form 8-K  
                                filed on January 8, 1997, File No. 0-24752)                                                        
         10.9          --       Registration Rights Agreement between Wave Systems Corp. and JNC Opportunity Fund Ltd., dated as of
                                December 27, 1996 (incorporated by reference to Exhibit 4.2 of the Registrant's Current Report on  
                                Form 8-K filed on January 8, 1997, File No. 0-24752)                                               
         10.10         --       Purchase Agreement between Wave Systems Corp. and JNC Opportunity Fund Ltd., dated as of May 30,   
                                1997 (incorporated by reference to Exhibit 4.1 of the Registrant's Current Report on Form 8-K filed
                                on June 3, 1997, File No. 0-24752)                                                                 
         10.11         --       Registration Rights Agreement between Wave Systems Corp. and JNC Opportunity Fund Ltd., dated as of
                                May 30, 1997 (incorporated by reference to Exhibit 4.2 of the Registrant's Current Report on Form  
                                8-K filed on June 30, 1997, File No. 0-24752)                                                      
         10.12         --       Purchase Agreement between Wave Systems Corp. and Combination, Inc., dated as of October 9, 1997   
                                (incorporated by reference to Exhibit 4.1 of the Registrant's Current Report on Form 8-K filed on  
                                October 15, 1997, File No. 0-24752)                                                                
         10.13         --       Registration Rights Agreement between Wave Systems Corp. and Combination Inc., dated as of October 
                                9, 1997 (incorporated by reference to Exhibit 4.2 of the Registrant's Current Report on Form 8-K    
                                filed on October 15, 1997, File No. 0-24752)                                                        


                                  -28-


<PAGE>

         10.14         --       Purchase Agreement between Wave Systems Corp. and Combination Inc., dated as of March 6, 1998      
                                (incorporated by reference to Exhibit 4.1 of the Registrant's Current Report on Form 8-K filed on  
                                March 19, 1998, File No. 0-24752)                                                                  
         10.15         --       Registration Rights Agreement between Wave Systems Corp. and Combination Inc., dated as of March 6,
                                1998 (incorporated by reference to Exhibit 4.2 of the Registrant's Current Report on Form 8-K filed
                                on March 19, 1998, File No. 0-24752)                                                               
         10.16         --       Addendum to License and Cross-License Agreement, dated February 28, 1997, between The Titan        
                                Corporation and Wave Systems Corp. (incorporated by reference to Exhibit 10.10 of the Registrant's 
                                Current Report on Form 10-K filed on March 24, 1997, file No. 0-24752).                            
         10.17         --       Convertible Promissory Note, dated January 26, 1999, between Carriage Partners, LLC and Wave       
                                Systems Corp.                                                                                      
         +10.18        --       Employment Contract, dated June 8, 1998, between Gerard T. Feeney and Wave Systems Corp.           
         +10.19        --       Employment Contract, dated November 10, 1998, between Steven Sprague and Wave Systems Corp.        
         23.1          --       Consent of Independent Auditors - KPMG Peat Marwick LLP                                            
         27            --       Financial Data Schedule
</TABLE>
                                
-------------------                                
+Confidential treatment has been granted as to portions of this exhibit.
+Management contract or compensatory plan.

    (b)  The Company filed a Form 8-K on March 19, 1998 in connection with the 
sale of its Series G Convertible Preferred Stock to Combination Inc.


                                      -29-


<PAGE>

                                   SIGNATURES

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

Dated:  March 31, 1999
                                                     WAVE SYSTEMS CORP.

                                        By:    /s/ Peter J. Sprague
                                           ------------------------
                                        Name:  Peter J. Sprague
                                        Title: Chairman, Chief Executive Officer
                                       

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

<TABLE>
<CAPTION>
           Signature                                      Title                                      Date
           ---------                                      -----                                      ----

<S>                                         <C>                                                 <C>   
  /s/ Peter J. Sprague          
-----------------------------
Peter J. Sprague                            Chairman and Chief Executive Officer                March 31, 1999


  /s/ Steven Sprague            
-----------------------------
Steven Sprague                              President, Chief Operating Officer and              March 31, 1999
                                                       Director

  /s/ John E. Bagalay, Jr.     
-----------------------------
John E. Bagalay, Jr.                                   Director                                 March 31, 1999

  /s/ Philippe Bertin          
-----------------------------
Philippe Bertin                                        Director                                 March 31, 1999

  /s/ George Gilder           
-----------------------------
George Gilder                                          Director                                 March 31, 1999

  /s/ John E. McConnaughy, Jr. 
-----------------------------
John E. McConnaughy, Jr.                               Director                                 March 31, 1999

  /s/ Gerard T. Feeney         
-----------------------------
Gerard T. Feeney                            Senior Vice President, Finance                      March 31, 1999
                                             and Administration, Chief Financial
                                             Officer and Secretary  (Principal
                                             Financial Officer and Duly Authorized
                                             Officer of the Registrant
</TABLE>


                                      -30-


<PAGE>

                                      F-1


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

                        Consolidated Financial Statements

                           December 31, 1998 and 1997

                   (With Independent Auditors' Report Thereon)

                   Index to Consolidated Financial Statements


<TABLE>
<CAPTION>
                                                                                                Page(s)
                                                                                                -------

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

Consolidated Balance Sheets as of December 31, 1998 and 1997                                     F-3

Consolidated Statements of Operations for each of the years ended December 31,
   1998, 1997 and 1996 and for the period from February 12,
   1988 (inception) through December 31, 1998                                                    F-4

Consolidated Statements of Stockholders' Equity (Deficiency) for each of the
   years ended December 31, 1998, 1997 and 1996 and for the period from
   February 12, 1988 (inception) through December 31, 1998                                       F-5

Consolidated Statements of Cash Flows for each of the years ended December 31,
   1998, 1997 and 1996 and for the period from
   February 12, 1988 (inception) through December 31, 1998                                      F-10

Notes to Consolidated Financial Statements                                                      F-12
</TABLE>


<PAGE>

                                      F-2


                          INDEPENDENT AUDITORS' REPORT



The Board of Directors and Stockholders
Wave Systems Corp.:


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

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Wave Systems Corp.
and subsidiaries as of December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 1998 and for the period from February 12, 1988 (date of
inception) to December 31, 1998 in conformity with generally accepted accounting
principles.


                                                       /s/ KPMG PEAT MARWICK LLP




Boston, Massachusetts
March 26, 1999


<PAGE>

                                      F-3


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

                           Consolidated Balance Sheets

                           December 31, 1998 and 1997


<TABLE>
<CAPTION>
         Assets
                                                                                        1998             1997
                                                                                        ----             ----
<S>                                                                                  <C>              <C>         
Current assets:
   Cash and cash equivalents                                                         $  1,057,094     $    758,721
   Prepaid expenses and other receivables                                                   5,000            -
                                                                                     ------------     ------------

         Total current assets                                                           1,062,094          758,721


Property and equipment, net                                                               888,261          849,276
Other assets                                                                              107,457           70,216
                                                                                     ------------     ------------

                                                                                        2,057,812        1,678,213
                                                                                     ============     ============


         Liabilities and Stockholders' equity (deficiency)

Current liabilities:
   Accounts payable and accrued expenses                                                3,029,158        1,427,762
   Deferred license fee                                                                 1,250,000     
                                                                                                             -
   Note payable                                                                           561,831          522,124
                                                                                     ------------     ------------

         Total current liabilities                                                      4,840,989        1,949,886
                                                                                     ------------     ------------

Series A Cumulative Redeemable Preferred Stock, $.01 par value.
   360 shares issued and outstanding in 1998 and 1997; involuntary
   liquidation value, $493,201                                                            493,201          471,601
                                                                                          -------          -------

Stockholders' Equity (deficiency):
   Series G Convertible Preferred stock, $.01 par value. 150,000 shares
     authorized and 20,000 outstanding in 1998                                            347,812            -
   Common stock, $.01 par value.  Authorized 75,000,000 shares as Class A;
     issued and outstanding 28,402,149 in 1998 and 22,874,639 in 1997                     284,022          228,747
   Common stock, $.01 par value.  Authorized 13,000,000 shares as Class B;
      issued and outstanding 3,140,665 in 1998 and 4,421,953 in 1997                       31,407           44,220
   Capital in excess of par value                                                      53,430,130       44,520,246
   Deficit accumulated during the development stage                                   (57,220,407)     (45,324,463)
   Less:  Note receivable from stockholder, including accrued interest
     of $101,167 in 1998 and $88,849 in 1997                                             (149,342)        (212,024)
                                                                                     -------------    -------------

         Total stockholders' deficiency                                                (3,276,378)        (743,274)
                                                                                     -------------    -------------

Commitments and contingencies

                                                                                     $  2,057,812     $  1,678,213
                                                                                      ===========     ============
</TABLE>

          See accompanying notes to consolidated financial statements.


<PAGE>

                                      F-4


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

                      Consolidated Statements of Operations

                Years ended December 31, 1998, 1997 and 1996 and
                period from February 12, 1988 (date of inception)
                            through December 31, 1998


<TABLE>
<CAPTION>
                                                                                                      Period from
                                                                                                   February 12, 1988
                                                                                                  (date of inception)
                                                                                                        through
                                                                                                      December 31,
                                                          1998              1997             1996         1998
                                                          ----              ----             ----         ----
                                                                                                  
<S>                                               <C>              <C>               <C>             <C>         
Net revenue                                       $     10,193      $     10,712     $      1,458    $     22,363
                                                  ------------      ------------     ------------     -----------

Operating expenses:
   Selling, general and administrative               9,874,166         7,983,151        5,560,620      37,310,672
   Write-off of goodwill                                    -            769,886               -          769,886
   Aladdin license and in process                                                   
     research and development expense                       -          3,889,000               -        3,889,000
   Research and development                          3,508,968         2,146,127        3,309,022      18,254,781
                                                    ----------       -----------      -----------      ----------
                                                                                    
                                                    13,383,134        14,788,164        8,869,642      60,224,339
                                                    ----------       -----------      -----------      ----------
                                                                                    
Other income (expense):                                                             
   License fee                                       2,750,000         1,000,000               -        3,750,000
   License warrant cost                             (1,100,000)                -                       (1,100,000)
   Interest income                                     111,009            55,282         194,766        1,169,341
   Interest expense                                   (284,012)         (175,624)        (10,397)        (850,492)
   Other Income                                             -                 -                -           12,720
                                                    ----------      ------------     -----------      -----------
                                                                   
                                                     1,476,997           879,658         184,369        2,981,569
                                                    ----------      ------------     -----------      -----------
                                                                   
          Net loss                                 (11,895,944)      (13,897,794)     (8,683,815)     (57,220,407)
                                                                   
Accrued dividends on preferred stock                               
   (including accretion of assured incremental                     
   yield on preferred stock of $750,000 in                       
   1998, $1,673,000 in 1997 and 620,965 in 1996)       858,863         2,482,982         870,579        4,337,358
                                                     ---------      ------------     -----------      -----------

          Net loss to common stockholders         $(12,754,807)     $(16,380,776)    $(9,554,394)    $(61,557,765)
                                                   ============     ============     ===========      ===========

Weighted average number of common
   shares outstanding during the period             29,299,844        20,943,748      14,956,584       11,570,172
Loss per common share                             $       (.44)    $        (.78)    $      (.64)    $      (5.32)
                                                   ===========      ============      ==========      ===========
</TABLE>

          See accompanying notes to consolidated financial statements.


<PAGE>

                                      F-5


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

          Consolidated Statements of Stockholders' Equity (Deficiency)

     Period from February 12, 1988 (date of inception) to December 31, 1998

<TABLE>
<CAPTION>                                                                                                         
                                                                                                                  
                                                                                                                  
                                                             Class A                Class B            Capital    
                                                          common stock           common stock       in excess of  
                                                       Shares       Amount     Shares     Amount      par value   
                                                       ------       ------     ------     ------      ---------   

<S>                                                       <C>        <C>     <C>        <C>           <C>         
Shares issued to founders at $.003 per share              -          $  -    4,680,000  $ 46,800      $(31,200)   
Shares issued at $1.25 per share, net of expenses of                                                              
   $36,574 from September through November 1988           -             -      300,000     3,000       335,426    
Net loss for period ended December 31, 1988               -             -           -         -             -     
                                                         ---          ----   ---------   -------      --------    
                                                                                                                  
Balance at December 31, 1988                              -             -    4,980,000    49,800       304,226    
                                                                                                                  
Shares issued at $1.25 per share, net of expenses of                                                              
   $68,750, from January through December 1989            -             -      270,000     2,700       266,050    
Shares issued at $1.25 per share in July 1989 as                                                                  
   compensation for services rendered                     -             -        1,920        19         2,400
Shares issued by principal stockholders at $1.25                                                                  
   per share in December 1989 as compensation                                                                     
   for services rendered                                  -             -           -         -        374,000    
Net loss for year ended December 31, 1989                 -             -           -         -             -     
                                                         ---          ----   ---------   -------      --------    
                                                                                                                  
Balance at December 31, 1989                              -             -    5,251,920    52,519       946,657    
                                                                                                                  
Shares issued by principal stockholder at $1.25                                                                   
   per share in March 1990 as compensation for                                                                    
   services rendered                                      -             -           -         -         56,250    
Shares issued by principal stockholder at   $.50 per                                                              
   share in March 1990 as compensation for                                                                        
   services rendered                                      -             -           -         -         60,000    
Shares issued at $1.67 per share in May 1990 as                                                                   
   compensation for services rendered                     -             -        6,000        60        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    
Net loss for year ended December 31, 1990                 -             -           -         -             -     
                                                         ---          ----   ---------   -------      --------    
                                                                                                                  
Balance at December 31, 1990                              -             -    5,647,920    56,479     1,713,947    
                                                                                                                  
Shares issued at $1.67 per share from March                                                                       
   through November 1991                                  -             -      315,000     3,150       521,850    
Shares issued at $1.67 per share in November                                                                      
   1991 as compensation for services rendered             -             -       19,800       198        32,802    
Net loss for year ended December 31, 1991                 -             -           -         -             -     
                                                         ---          ----   ---------   -------      --------    
                                                                                                                  
Balance at December 31, 1991 (carried forward)            -             -    5,982,720    59,827     2,268,599    


<CAPTION>                                                                                                         
                                                         Deficit                                                  
                                                       accumulated                          Note                  
                                                        during the                        receivable              
                                                       development       Deferred           from                  
                                                          stage        compensation      stockholder       Total  
                                                          -----        ------------      -----------       -----  
                                                                                                                  
<S>                                                    <C>                 <C>              <C>         <C>       
Shares issued to founders at $.003 per share                 $ -           $ -              $ -         $  15,600 
Shares issued at $1.25 per share, net of expenses of                                                              
   $36,574 from September through November 1988                -             -                -           338,426 
Net loss for period ended December 31, 1988              (326,832)           -                -          (326,832)
                                                       ----------          ----              ----       --------- 
                                                                                                                  
Balance at December 31, 1988                             (326,832)           -                -            27,194 
                                                                                                                  
Shares issued at $1.25 per share, net of expenses of                                                              
   $68,750, from January through December 1989                 -             -                -           268,750 
Shares issued at $1.25 per share in July 1989 as                                                                  
   compensation for services rendered                       2,381            -                -             2,400
Shares issued by principal stockholders at $1.25                                                                  
   per share in December 1989 as compensation                                                                     
   for services rendered                                       -             -                -           374,000 
Net loss for year ended December 31, 1989                (982,186)           -                -          (982,186)
                                                       ----------          ----              ----       --------- 
                                                                                                                  
Balance at December 31, 1989                           (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 
Shares issued by principal stockholder at   $.50 per                                                              
   share in March 1990 as compensation for                                                                        
   services rendered                                           -             -                -            60,000 
Shares issued at $1.67 per share in May 1990 as                                                                   
   compensation for services rendered                       9,940            -                -            10,000
Shares issued at $1.67 per share, net of expenses of                                                              
   $5,000 in March, April, November and December 1990          -             -                -           645,000 
Net loss for year ended December 31, 1990              (1,178,129)           -                -        (1,178,129)
                                                       ----------          ----              ----       --------- 
                                                                                                                  
Balance at December 31, 1990                           (2,487,147)           -                -          (716,721)
                                                                                                                  
Shares issued at $1.67 per share from March                                                                       
   through November 1991                                       -             -                -           525,000 
Shares issued at $1.67 per share in November                                                                      
   1991 as compensation for services rendered                  -             -                -            33,000 
Net loss for year ended December 31, 1991              (1,009,368)           -                -        (1,009,368)
                                                       ----------          ----              ----       --------- 
                                                                                                                  
Balance at December 31, 1991 (carried forward)         (3,496,515)           -                -        (1,168,089)
</TABLE>


<PAGE>

                                      F-6


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

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


<TABLE>
<CAPTION>                                                                                                                          
                                                                                                                         Deficit
                                                                                                                       accumulated
                                                                  Class A                Class B            Capital     during the 
                                                               common stock           common stock       in excess of   development
                                                            Shares       Amount     Shares     Amount      par value       stage   
                                                            ------       ------     ------     ------      ---------       -----   
                                                                                                                      
<S>                                                            <C>           <C>  <C>           <C>        <C>          <C>        
Balance at December 31, 1991 (brought forward)                 -             -    5,982,720     59,827     2,268,599    (3,496,515)
                                                                                 
Shares issued at $1.67 per share from January through                            
  October 1992                                                 -             -      708,000      7,080     1,172,920            -  
Shares issued at $1.67 per share in May 1992 in connection                       
   with License and Cross-License Agreement                    -             -      674,976      6,750     1,118,210            -  
Shares issued at $1.67 per share in May 1992 as                                  
   compensation for services rendered                          -             -       18,000        180        29,820       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            -  
Shares issued at $2.50 per share, net of expenses                                
   of $7,500, in November and December 1992                    -             -      323,001      3,230       796,773            -  
Shares issued by principal stockholder in                                        
   December 1992 at $2.50 per share as                                           
   compensation for services rendered                          -             -            -          -        75,000       75,000
Shares canceled in October and December 1992                   -             -      (75,000)      (750)          750            -  
Issuance of stock options at $.003 exercise price                                
   per share in June 1992                                      -             -           -          -        798,400            -  
Amortization of deferred compensation                          -             -           -          -             -        155,455
Accrued dividends on preferred stock                           -             -           -          -         (6,383)       (6,383)
Note received from stockholder and accrual of                                    
   interest thereon                                            -             -           -          -             -             -  
Net loss for year ended December 31, 1992                      -             -           -          -             -     (4,182,638)
                                                              ---           ---         ---        ---           ---     --------- 
                                                                                 
Balance at December 31, 1992 (carried forward)                 -             -    8,402,697     84,027     8,173,879    (7,679,153)


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

<PAGE>

                                      F-7


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

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

<TABLE>
<CAPTION>
                                                                                                                     Deficit        
                                                                                                                   accumulated      
                                                                    Class A                Class B            Capital    during the 
                                                                 common stock           common stock       in excess of  development
                                                              Shares       Amount     Shares     Amount      par value      stage   
                                                              ------       ------     ------     ------      ---------      -----   

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


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

<PAGE>

                                      F-8


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

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

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


<CAPTION>                                                                                                               
                                                             Deficit                                                    
                                                           accumulated                         Note                    
                                                           during the                       receivable                 
                                                           development       Deferred          from                    
                                                              stage        compensation     stockholder        Total   
                                                              -----        ------------     -----------        -----   
                                                                                                                       
<S>                                                       <C>                    <C>        <C>            <C>         
Balance at December 31, 1994 (brought forward)             (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            -            -                 -            57,499 
Exercise of options to purchase Class B stock                       -            -                 -           436,230 
Accrued dividends on preferred stock                                -            -                 -           (40,600)
Accrual of interest on note receivable from stockholder             -            -            (17,318)         (17,318)
Exchange of Class B stock for Class A stock                         -            -                 -                -  
Net loss for the year ended December 31, 1995               (6,832,866)          -                 -        (6,832,866)
                                                            ----------          ---           -------          ------- 
                                                                                                                       
Balance at December 31, 1995                               (22,742,854)          -           (227,390)       6,152,730 
                                                                                                                       
Exercise of options to purchase Class A stock                       -            -                 -           422,507 
Shares issued at prices ranging from $2.06 per share to                                                                
   $3.44 per share as compensation for services rendered            -            -                 -           123,450 
Issuance of unregistered Class B common stock to acquire                                                               
   Wave Interactive Network valued at approximately                                                                    
   $.98 per share                                                   -            -                 -           368,438 
Issuance of warrants to purchase unregistered shares of                                                                
   Class A common stock in conjunction with the issuance                                                               
   of convertible debt and preferred stock                          -            -                 -           283,455 
Conversion of Class B Preferred Stock                               -            -                 -         3,108,524 
Accrual of interest on note receivable                              -            -            (17,3150         (17,315)
Accrued dividends on preferred stock                                -            -                 -          (199,014)
Exchange of Class B stock for Class A stock                         -            -                 -                -  
Net loss for the year ended December 31, 1996               (8,683,815)          -                 -        (8,683,815)
                                                            ----------          ---           -------          ------- 
                                                                                                                       
Balance at December 31, 1996                               (31,426,669)          -           (244,705)       1,558,960 
                                                            ----------          ---           -------          ------- 
                                                                                                                       
Exercise of options to purchase Class A and B common stock          -            -                 -           139,888 
Shares issued at prices ranging from $1.00 per share                                                                   
   to $3.00 per share as compensation for services                                                                     
   rendered                                                         -            -                 -           305,496 
Conversion of preferred stock into common stock                     -            -                 -         6,783,017 
Issuance of Class A common stock and warrants to                                                                       
   purchase Class A common stock to Aladdin                         -            -                 -         3,839,000 
Issuance of Class A common stock and warrants to                                                                       
   purchase Class A common stock                                    -            -                 -           800,000 
Reduction in note receivable                                        -            -             50,000           50,000 
Accrual of interest on note receivable                              -            -            (17,319)         (17,319)
Issuance of warrants to purchase Class A common stock                                                                  
   in conjunction with the issuance of preferred stock              -            -                 -           386,462 
Accrued dividend on preferred stock including accretion                                                                
   of assured incremental yield                                     -            -                 -        (1,372,984)
Assured incremental yield on issuance of Series F                                                                      
   convertible preferred stock and debt                             -            -                 -           682,000 
Net loss                                                   (13,897,794)          -                 -       (13,897,794)
Exchange of Class B stock for Class A stock                         -            -                 -                -  
                                                            ----------          ---           -------          ------- 
                                                                                                                       
Balance at December 31, 1997                              $(45,324,463)        $ -          $(212,024)       $(743,274)
</TABLE>

                                                          
          See accompanying notes to consolidated financial statements.


<PAGE>

                                      F-9


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

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


<TABLE>
<CAPTION>                                                                                                                   
                                                                       Class A                Class B              Capital      
                                                                    common stock           common stock         in excess of    
                                                                 Shares       Amount     Shares     Amount        par value     
                                                                 ------       ------     ------     ------        ---------     
                                                                                                                                
<S>                                                            <C>           <C>       <C>          <C>         <C>             
Balance at December 31, 1997                                   22,874,639    $228,747   4,421,953   $44,220     $44,520,246     
                                                               ----------     -------  -----------  --------      ---------     
                                                                                                                                
Exercise of options to purchase Class A common stock               77,558         775                               151,180     
Options issued to employees below fair market-value                  -           -           -         -            234,723     
Exercise of warrants to purchase Class A common stock           1,652,770      16,528        -         -          3,945,740        
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     
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     
Reduction in note receivable                                         -           -           -         -               -        
Issuance of Series G Convertible Preferred stock and                                                                          
   Common stock warrants, net of issuance costs of $222,500          -           -           -         -            218,250     
Assured incremental yield on issuance of Series G                                                                               
   convertible preferred stock and debt                              -           -           -         -            750,000
Accrual of interest on note receivable                               -           -           -         -               -        
Accrued dividend on preferred stock including accretion                                                                   
   of assured incremental yield                                      -           -           -         -           (858,863)    
Conversion of Series G Preferred Stock                          2,394,494      23,945        -         -          2,274,756     
Net loss                                                             -           -           -         -               -        
Exchange of Class B stock for Class A stock                     1,281,288      12,813  (1,281,288)  (12,813)           -      
                                                               ----------     -------  -----------  --------      ---------     
                                                                                                                               
Balance at December 31, 1998                                   28,402,149    $284,022   3,140,665   $31,407     $53,430,130     
                                                               ==========     =======   =========    ======      ==========     
                                                         

<CAPTION>                                                                                                              
                                                                   Deficit                                                     
                                                                 accumulated      Series G           Note                     
                                                                 during the      Convertible      receivable                  
                                                                 development      Preferred          from                     
                                                                    stage           Stock         stockholder        Total    
                                                                    -----           -----         -----------        -----    
                                                                                                                       
<S>                                                             <C>              <C>              <C>            <C>         
Balance at December 31, 1997                                    $(45,324,463)          -          $(212,024)       $(743,274)
                                                                  ----------        -------         -------       ---------- 
                                                                                                                             
Exercise of options to purchase Class A common stock                     -             -               -             151,955 
Options issued to employees below fair market-value                      -             -               -             234,723 
Exercise of warrants to purchase Class A common stock                    -             -               -           3,962,268 
Warrants to purchase Class A common stock                                                                                    
   to be issued to ITG as part of technology licensing                                                                     
   agreement and issued to consultants for services                      -             -               -           1,546,824 
Shares issued at prices ranging from $1.00 per share                                                                         
   to $5.00 per share as compensation for services                                                                           
   rendered                                                              -             -               -             648,488 
Reduction in note receivable                                             -             -             75,000           75,000 
Conversion of Series G Preferred Stock                                   -       (2,298,701)           -                 -   
Issuance of Series G Convertible Preferred stock and                                                                         
   Common stock warrants, net of issuance costs of $222,500              -        1,809,250            -           2,027,500
Accrual of interest on note receivable                                   -             -            (12,318)         (12,318)   
Accrued dividend on preferred stock including accretion                                                                      
   of assured incremental yield                                          -          837,263            -             (21,600)
Assured incremental yield on issuance of Series G                                                                            
   convertible preferred stock and debt                                  -             -               -             750,000 
Net loss                                                         (11,895,944)          -               -         (11,895,944)
Exchange of Class B stock for Class A stock                              -             -               -                 -   
                                                                  ----------        -------         -------       ---------- 
                                                                                                                             
Balance at December 31, 1998                                    $(57,220,407)     $ 347,812       $(149,342)     $(3,276,378)
                                                                =============     =========       ==========     ============
</TABLE>                                                

                                                          
          See accompanying notes to consolidated financial statements.


<PAGE>

                                      F-10


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

                      Consolidated Statements of Cash Flows

            Years ended December 31, 1998, 1997, 1996 and the Period
      From February 12, 1988 (Date of Inception) through December 31, 1998
 

<TABLE>
<CAPTION>
                                                                                                               Period from
                                                                                                            February 12, 1988
                                                                                                           (date of inception)
                                                                                                                 through
                                                                                                               December 31,
                                                              1998              1997            1996               1998
                                                              ----              ----            ----               ----
                                                                                                         
<S>                                                      <C>               <C>               <C>              <C>          
Cash flows from operating activities:                
   Net loss                                              $(11,895,944)     $(13,897,794)     $(8,683,815)     $(57,220,407)
   Adjustments to reconcile net loss to net cash     
    used in operating activities:                    
     Write-off of goodwill                                       -              769,886             -              769,886
     Depreciation and amortization                            332,741           486,693          316,829         1,520,109
       Reserve for note from affiliate                           -                 -           1,004,934         1,672,934
     Accrued interest on marketable securities                   -                                48,617          (106,962)
     Noncash expenses:                               
       Accretion of assured incremental yield on     
          convertible debt                                       -              119,000             -              119,000
       Common stock issued in connection with        
          License and Cross-License Agreement                    -                 -                -            1,124,960
       Common stock issued for services rendered     
          and additional interest on borrowings               648,488           305,496           40,938         3,325,546
       Warrants to be issued to ITG and warrants     
          issued as compensation for services               1,546,824              -                -            1,546,824
       Issuance of warrants to Aladdin                           -            2,939,000             -            2,939,000
       Accrued interest on note payable                        39,707            56,624            9,500           105,831
       Preferred stock issued for services rendered              -                 -                -              265,600
       Compensation associated with issuance of          
          stock options                                       234,723              -                -              634,463
       Amortization of deferred compensation                     -                 -                -              398,660
       Amortization of discount on notes payable                 -                 -                -              166,253
       Common stock issued by principal stockholder                                                              
          for services rendered                                  -                 -                -              565,250
     Changes in assets and liabilities:                                                                        
       Increase in Deferred License fee                     1,250,000              -                -            1,250,000
       Increase in accrued interest on note receivable        (12,318)          (17,319)         (17,315)         (101,168)
       (Increase) decrease in prepaid expenses and
          other receivables                                    (5,000)           70,358           64,413            (5,000)
       (Increase) decrease in other assets                    (37,241)          184,771          (53,346)         (122,373)
       (Decrease) increase in accounts payable and          
          accrued expenses                                  1,601,396           490,599         (191,103)        3,166,670
                                                          -----------         ---------     -------------      -----------

          Net cash used in operating activities            (6,296,624)       (8,492,686)      (7,460,348)      (37,984,924)
                                                          -----------        -----------     -----------        ----------
</TABLE>

                                                                     (Continued)


<PAGE>

                                      F-11


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

                Consolidated Statements of Cash Flows, Continued


<TABLE>
<CAPTION>
                                                                                                               Period from
                                                                                                            February 12, 1988
                                                                                                           (date of inception)
                                                                                                                 through
                                                                                                               December 31,
                                                              1998              1997            1996               1998
                                                              ----              ----            ----               ----
                                                                                                         
<S>                                                      <C>                <C>              <C>             <C>          
Cash flows from investing activities:
   Acquisition of property and equipment                     (371,726)         (256,306)        (252,439)       (2,178,844)
   Short-term loans to affiliate                                -                 -           (1,004,934)       (1,672,934)
   Organizational costs                                         -                 -                -            (14,966)
   Purchase of marketable securities-held to maturity           -                 -           (2,945,458)      (27,546,769)
   Maturity of marketable securities-held to maturity           -                 -            6,843,041        27,653,731
                                                           ----------         ----------      ----------       -----------
                                                                                           
          Net cash provided by (used in) investing          
            activities                                       (371,726)         (256,306)       2,640,210        (3,759,782)
                                                           ----------         ----------      ----------       -----------

Cash flows from financing activities:
   Net proceeds from issuance of common stock               4,114,223         1,837,889          422,507        28,523,694
   Net proceeds from issuance of preferred stock           
     and warrants                                           2,777,500         3,555,500        5,950,027        12,283,027
   Sale of warrants                                             -                 -                -                     4
   Note receivable from stockholder                            75,000            50,000            -               (48,175)
   Proceeds from notes payable and warrants to                                                             
     stockholders                                               -                 -                -             2,083,972
   Repayments of notes payable to stockholders                  -                 -                -            (1,069,972)
   Proceeds from notes payable and warrants                     -                 -                -             1,284,250
   Repayments of note payable                                   -                 -                -              (255,000)
   Advances from stockholder                                    -                 -                -               227,598
   Repayments of advances from stockholder                      -                 -                -              (227,598)
   Increase in deferred offering costs                          -                 -                -                 - 
                                                            ---------         ---------      -----------        ----------
                                                          
          Net cash provided by financing activities         6,966,723         5,443,389        6,372,534        42,801,800
                                                            ---------         ---------      -----------        ----------
                                                          
Net increase (decrease) in cash and cash equivalents          298,373        (3,305,603)       1,552,396         1,057,094
                                                           
Cash and cash equivalents at beginning of period              758,721         4,064,324        2,511,928             - 
                                                            ---------         ---------      -----------        ----------
                                                        
Cash and cash equivalents at end of period               $  1,057,094       $   758,721      $ 4,064,324     $   1,057,094
                                                          ===========       ===========        =========      ============
</TABLE>                                                

                                                          
          See accompanying notes to consolidated financial statements.


<PAGE>

                                      F-12

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

                   Notes to Consolidated Financial Statements

       December 31, 1998, 1997, 1996 and The Period From February 12, 1988
                 (Date of Inception) Through December 31, 1998


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

   The Company has incurred significant losses in current and prior periods.
     Management intends to continue to devote resources toward the research,
     development and marketing of its products in order to generate future
     revenues from licensing and product sales. In addition, the Company is
     actively pursuing additional short- and long-term financing sources,
     including debt and equity financing and on March 23, 1999 completed an
     offering of common stock for net proceeds of approximately $23 million, as
     discussed in Note 13. Management anticipates that the proceeds of this
     offering will be sufficient to fund operations through the end of the third
     quarter of 2000. However, while management believes that it can
     successfully research, develop and market its products and obtain
     additional financing to fund operations beyond 2000, there can be no
     assurance that it will be able to do so.

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

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

   (c) Cash Equivalents
     For purposes of the consolidated statements of cash flows, the Company
       considers all highly liquid instruments with a maturity of three months
       or less to be cash equivalents.

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


<PAGE>

                                      F-13

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

            Notes to Consolidated Financial Statements - (Continued)


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

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

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

   (h) Research and Development
     Research and development costs are expensed as incurred.


<PAGE>

                                      F-14

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

            Notes to Consolidated Financial Statements - (Continued)


   (i) Loss Per Share
     Basic net loss per common share has been calculated based upon the weighted
     average number of shares of common stock outstanding during the period. No
     effect has been given to common stock equivalents or convertible preferred
     stock, warrants or debt in the diluted loss per common share as they are
     all anti-dilutive. Included in net loss to common stockholders is the
     accretion of the assured incremental yield related to the ability of the
     Series B, C, D, F and G preferred stockholders to acquire common stock upon
     conversion at a discount. The assured incremental yield is being accreted
     as a dividend over the periods from the dates of issuance of the preferred
     stock to the earliest eligible dates for conversion.

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

   (k) Reclassifications
     Certain reclassifications have been made to the 1996 and 1997 consolidated
financial statements to conform to the 1998 presentation.

(3) Related Party Transactions
   (a) Note Receivable from Stockholder
     A stockholder, the Chairman and Chief Executive Officer of the Company, was
       indebted to the Company at December 31, 1998 and 1997 under two
       promissory notes totaling $149,342, including accrued interest, due on
       demand. During 1998 and 1997, $75,000 and $50,000, respectively, of the
       Chairman and Chief Executive Officer's bonus was used to reduce the
       principal owed.

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

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

     In 1998,  the Company paid $25,000 to Studio 2, during which time Mr. Kevin
       Sprague was an employee of Studio 2. Kevin Sprague is the son of the 
       Chairman and CEO of the Company.


                                                                     (Continued)


<PAGE>

                                      F-15

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

             Notes to Consolidated Financial Statements, (Continued)


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

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

     The purchase price of $952,438 was determined based on the estimated fair
       value of the consideration given to the WIN shareholders and noteholders
       and was allocated to goodwill as WIN had no net tangible assets.
       Subsequently, in 1997, the Company determined it was uncertain whether
       the current and expected future results of operations of WIN would be
       adequate to support the goodwill capitalization, and wrote-off the
       goodwill as impaired. If the contingent consideration of an additional
       325,000 shares is issued, the value ascribed to such consideration will
       be expensed.


<PAGE>

                                      F-16

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

             Notes to Consolidated Financial Statements, (Continued)




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

<TABLE>
<CAPTION>
                                                                     1998                     1997
                                                                     ----                     ----

       <S>                                                       <C>                     <C>        
       Equipment                                                 $ 1,554,001             $ 1,297,702
       Furniture, fixtures and improvements                          459,822                 389,530
       Computer software                                             171,363                 128,228
                                                                  ----------              ----------
                                                                   2,185,186               1,815,460
       Less: Accumulated depreciation                              1,296,925                 966,184
                                                                  ----------              ----------
          Total                                                  $   888,261             $   849,276
                                                                  ==========              ==========
</TABLE>


   Depreciation expense on property and equipment amounted to approximately
     $333,000, $344,000, $272,000 and $1,297,000 for the years ended December
     31, 1998, 1997, and 1996 and for the period from inception through December
     31, 1998, respectively.

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

   On October 18, 1998 the Company restated and amended the note. The note is
     now convertible any time after April 1, 1999 and up to April 18, 1999. The
     conversion price was reduced to $0.95 per share of common stock. An
     additional 75,000 warrants were issued as part of this amended note and the
     fair value of these warrants was $106,000. Additionally, the fair value of
     the reduced conversion price was $274,000. Such amounts will be amortized
     as additional interest expense from the date the note was amended and
     warrant issued through the earliest conversion date of April 1, 1999.
     During 1998, approximately $123,000 of the value of the reduced conversion
     rate and warrant was recorded as interest expense.

(6) Accounts Payable and Accrued Expenses
   Accounts payable and accrued expenses as of December 31 consisted of the
     following:

<TABLE>
<CAPTION>
                                                                                  1998                  1997
                                                                                  ----                  ----

<S>                                                                          <C>                    <C>       
       Accrual of costs related to the ITG agreement                           $ 490,000              $ 490,000 
       Accounts payable                                                          755,521                298,486
       Accrued consulting and professional fees                                  155,000                264,495
       Legal Settlement (note 13                                                 602,000                  -
       Accrued payroll and related costs                                         816,269                318,403
       Lease payable                                                              60,169                  -
       Other accrued liabilities                                                 150,199                 56,378
                                                                               ---------              ---------

          Total                                                              $ 3,029,158            $ 1,427,762
                                                                               =========              =========
</TABLE>


<PAGE>

                                      F-17

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

             Notes to Consolidated Financial Statements, (Continued)


(7) Capital Stock
   (a) Redeemable Preferred Stock
     The Company has authorized 2,000,000 shares of preferred stock having a par
       value of $.01 per share. On October 19, 1992, the Board of Directors
       designated and issued 360 shares of this preferred stock of the Company
       as "Series A Cumulative Redeemable Preferred Stock" ("Series A Preferred
       Stock").

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

     N dividends may be declared upon the common stock of the Company unless
       full cumulative dividends on the Series A Preferred Stock have been
       declared and a sum sufficient for the payment thereof has been set apart
       for such payment. The stock is non-voting and redeemable at $1,000 per
       share, plus accumulated dividends, at any time at the option of the
       Company. The stock is subject to mandatory redemption five years from the
       date of issuance, or October 1997. Because the dividend rate on the
       Preferred Stock was below market rates, the stock was discounted to yield
       a market rate of 12% at the time of issuance, resulting in a discount of
       $94,400. Dividends of $21,600, $39,267, and $41,800 have been accrued for
       the years ended December 31, 1998, 1997 and 1996, respectively. The
       holder has not notified the Company of his intention to redeem the stock.
       The Company continues to accrue dividends until receipt of such
       intention.

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

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

                                                                     (Continued)


<PAGE>

                                      F-18

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

             Notes to Consolidated Financial Statements, (Continued)


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

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

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

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

   (b) Convertible Preferred Stock

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


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


     During March of 1998, the Company issued 150,000 shares of newly created
       Series G Convertible Preferred stock for an aggregate purchase price of
       $3,000,000. The Series G Convertible preferred stock is senior to the
       Company's classes of common stock, and is junior to the Company' Series A
       Redeemable Preferred in liquidation rights. The Series G Convertible
       Preferred Stock accrues dividends at the rate of 6% per annum. The Series
       G Convertible Preferred stock is convertible into the Company's
       unregistered Class A Common stock at the lower of $1.12 or 80% of the
       average of the five lowest closing bids for the 25 calendar days prior to
       conversion. In addition, the Company issued warrants to the purchaser and
       placement agent for 225,000 shares of the Company's Class A common stock
       at an exercise price of $1.38. As of December 31, 1998, 20,000 shares
       remained outstanding.

                                                                     (Continued)


<PAGE>

                                      F-19

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

             Notes to Consolidated Financial Statements, (Continued)

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

     Two principal stockholders did not acquire the full amount of shares to
       which they were entitled. Most of the additional proportionate shares
       that these stockholders would have been credited with were offered
       instead to certain officers, employees and stockholders for $.003 per
       share. To the extent that these rights were offered to the individuals in
       compensation for services rendered to the Company, compensation expense
       equal to the difference between the estimated fair value as of the date
       of issuance and the purchase price of the stock was recorded. The
       estimated fair value of the common stock was determined based on sales to
       third parties near the date of issuance. Compensation expense associated
       with the issuance of these shares of $430,250 is included in the
       accompanying consolidated statement of operations for the period from
       inception to December 31, 1998.

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

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

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

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

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

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


                                                                     (Continued)


<PAGE>

                                      F-20

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

             Notes to Consolidated Financial Statements, (Continued)


     During 1997 the Company sold approximately 800,000 shares of the Company's
       Class A common stock and warrants to purchase 160,000 shares of the
       Company's Class A common stock, which may be exercised at an exercise
       price of $1.00, for an aggregate purchase price of $800,000. As of
       December 31, 1998, 600,000 of the shares had been exercised.

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

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

(8) Options and Warrants


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

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

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


                                                                     (Continued)


<PAGE>

                                      F-20

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

             Notes to Consolidated Financial Statements, (Continued)


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

   1994 Plans
   In January 1994, the Board of Directors authorized the establishment of the
     1994 Employee Stock Option Plan (the "1994 Plan"). The initial number of
     shares of Class A common stock subject to the 1994 Plan was 1,000,000. The
     terms of the 1994 Plan are similar to those of the 1991 Plan. Options are
     granted with exercise prices that approximate fair market value at the date
     of grant. In May 1996, July 1997, and November 1998 the Board of Directors
     approved an amendment to the Company's 1994 Plan to increase the number of
     shares of Class A common stock reserved for issuance thereunder by
     1,000,000, 1,000,000 and 5,000,000, respectively. Therefore, the 1994 Plan
     number of shares of Class A common stock reserved for issuance is 8,000,000
     shares.

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

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

   In February 1995, the Board of Directors authorized certain changes to the
     Directors' Plan. The annual option grant for directors was increased from a
     total of 2,000 shares of Class A common stock to 10,000 shares of Class A
     common stock. In July 1995, the stockholders of the Company authorized an
     increase to the total number of shares subject to the Directors' Plan from
     200,000 shares to 500,000 shares. Options to purchase a total of 110,000
     and 100,000 shares of Class A common stock at $1.94 to $3.09 and $3.09 per
     share, were issued in 1997 and 1996, respectively, to nonemployee
     directors. In November 1998, the stockholders of the Company authorized an
     increase to the total number of shares subject to the Directors' Plan from
     500,000 shares to 1,000,000 shares. The stockholders also amended the
     Directors' Plan to provide that options issued to non-employee directors
     under such plan vest on the day following the grant.

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

                                                                     (Continued)


<PAGE>

                                      F-22

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

             Notes to Consolidated Financial Statements, (Continued)


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

   In September 1996, the Board of Directors authorized the establishment of the
     1996 Performance Stock Option Plan ( the "1996 Plan"). The initial number
     of shares of Class A common stock subject to the 1996 Plan was 800,000. The
     terms of the 1996 Plan are similar to those of the 1994 and 1991 Plans.
     Options are granted with exercise prices that approximate fair market value
     at the date of grant.

   At December 31, 1998, there were approximately 3,360,000 additional shares
     available for grant under the 1994 Plan. The per share weighted-average
     fair value of stock options granted during 1998, 1997 and 1996 was $2.48,
     $1.58 and $2.65 on the dates of grant using the Black Scholes
     option-pricing model with the following weighted-average assumptions:

<TABLE>
<CAPTION>
                                                  1998             1997              1996
                                                  ----             ----              ----

       <S>                                        <C>              <C>               <C>
       Expected Life (Years)                       10               10                10
       Interest Rate                              6.0%             6.5%              6.4%
       Volatility                                 105%             111%              124%
       Dividend Yield                               0%               0%                0%
</TABLE>

   The Company applies APB Opinion No. 25 in accounting for its Plans and,
     accordingly, no compensation cost has been recognized for stock options
     granted to employees at fair market value in the financial statements,
     except for $234,723 of expense recorded in 1998 for options issued at
     exercise prices below the fair market value of the Company's stock.

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

<TABLE>
<CAPTION>
                                                                 1998                1997              1996
                                                                 ----                ----              ----
                                                                
     <S>                                                  <C>                  <C>               <C>        
     Net loss - as reported                                $ (11,895,944)     $ (13,897,794)    $ ( 8,683,815)
     Net loss - pro forma                                    (17,596,312)       (15,300,187)      (10,025,517)
     Net loss to common stockholders - as reported           (12,754,807)       (16,380,776)       (9,554,394)
     Net loss to common shareholders - pro forma             (18,455,175)       (17,783,169)      (10,896,096)
     Loss per common share - as reported                           ( .44)              (.78)             (.64)
     Loss per common share - pro forma                             ( .63)              (.85)             (.73)
</TABLE>


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

                                                                     (Continued)


<PAGE>

                                      F-23

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

             Notes to Consolidated Financial Statements, (Continued)

Summary of Option Activity
A summary of option activity through December 31, 1998 follows:

<TABLE>
<CAPTION>
                                                                 Class A and B shares             Weighted average
                                                                   subject to option               exercise price
                                                                   -----------------               --------------
<S>                                                                       <C>                            <C> 
Balance at January 1, 1991                                                    -                      $  - 
Options granted                                                           30,000                         1.67
                                                                     -----------

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

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

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

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

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

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

Balance at December 31, 1997                                           1,944,790                         2.73
Options granted                                                        5,665,278                         2.48
Options canceled                                                        (701,267)                                 2.49
Options exercised                                                      (  77,558)                        1.95
                                                                   -------------

Balance at December 31, 1998                                           6,831,243                        $2.48
</TABLE>

   At December 31, 1998, there were approximately 1,760,568 options exercisable
at prices ranging from $1.06 to $7.06.

                                                                     (Continued)

                                      F-24
<PAGE>


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

             Notes to Consolidated Financial Statements, (Continued)

The following table summarizes information about stock options outstanding at
December 31, 1998:

<TABLE>
<CAPTION>
                                                                                                        Weighted
                                                                                   Weighted              average
                                                                                    average             remaining
Range of                                      Number           Number              exercise            contractual
exercise prices                             outstanding      exercisable             price                life
---------------                             -----------      -----------             -----                ----
<S>                                           <C>               <C>                 <C>                 <C>      
   $1.06                                      131,250           50,167              $1.06               8.6 years
   1.07 - 1.69                              3,009,675          350,209               1.30               8.5 years
   1.70 - 2.31                                174,634           44,536               2.10               8.8 years
   2.32 - 2.97                                 89,243           72,707               2.62               5.7 years
   2.98 - 3.50                                870,767          291,669               3.32               8.2 years
   3.51 - 3.81                              2,254,894          878,500               3.66               9.4 years
   3.82 - 7.06                                300,780           72,780               7.06               8.6 years
</TABLE>

   Warrants

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

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

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

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

                                                                     (Continued)

                                      F-25
<PAGE>

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

             Notes to Consolidated Financial Statements, (Continued)

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

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

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

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

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

   In connection with a technology license agreement with Aladdin, the Company
     issued two warrants on July 18, 1997 to purchase the Company's Class A
     Common Stock. The first warrant is exercisable in 100,000 share lots, and
     provides the holder with the right to acquire 1,216,136 shares of the
     Company's unregistered Class A Common Stock at an exercise price of $1.70
     per share. The first warrant has a life of two years. The second warrant
     provides the holder with the right to acquire 7% of the Company's Class A
     Common Stock on a fully diluted basis for the average closing price for the
     15 trading days prior to exercise. During June of 1998, Aladdin exercised a
     portion of the second warrant to purchase 1,000,000 shares of common stock
     and still has the right to acquire shares approximating 3.45% of the
     Company's Class A common stock.

                                                                     (Continued)

                                      F-26
<PAGE>

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

             Notes to Consolidated Financial Statements, (Continued)


   A summary of warrants outstanding at December 31, 1998, based upon a year end
price of the Class A common stock of $3.718 per share, follows:

<TABLE>
<CAPTION>
                                                                         Range of
                                         Class A and B shares            exercise            Expiration
 Year of issuance                         subject to warrants             prices                Term
 ----------------                         -------------------             ------                ----
<S>                                            <C>                     <C>      <C>           <C>    
   1994                                        542,800                 $ 3.50 - 6.50          5 years
   1996                                        191,905                   1.25 - 3.09       5-10 years
   1997                                      1,080,000                   1.00 - 1.75          5 years
   1997                                      1,216,136                          1.70          2 years
   1998                                        225,000                   1.38 - 1.49          5 years
                                               120,000                   1.10 - 4.05          5 years
                                                34,680                          1.83         10 years
                                            ---------
                                            3,410,521
                                            =========
</TABLE>

   At December 31, 1998, warrants to acquire approximately 3.4 million shares of
Class A and Class B common stock were exercisable.

   The above information table does not include the Aladdin warrant to purchase
3.45% of the Company due to its variable nature.

(9) Licensing Agreements

   (a) Licensed Patents

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

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

                                                                     (Continued)

                                      F-27
<PAGE>

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

Notes to Consolidated Financial Statements, (Continued)

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

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

   (b) Aladdin License Agreement

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

   The Company acquired the license for this technology in exchange for $950,000
     plus two warrants to purchase the Company's Class A common stock valued at
     approximately $2.9 million (see note 8). The cost of this license was
     expensed as research and development costs. Aladdin also is provided a
     royalty payment of 5% to 9% of the Company's net content revenues.

   Inconnection with this agreement, Aladdin acquired an equity position in the
     Company by purchasing 500,000 shares of the Company's Class A common stock
     for $900,000, which approximated the fair market value of the shares on the
     date of purchase (see note 7).

(10) License and Cross-License Agreements

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

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

                                                                     (Continued)

                                      F-28
<PAGE>

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

             Notes to Consolidated Financial Statements, (Continued)

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

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

   A director of the Company, who resigned from the Board at the end of 1997, is
     also the President, Chief Executive Officer, and a director of Titan.
     Pursuant to the terms of a related stockholders agreement, Titan has the
     right to designate a member of the Company's Board of Directors for as long
     as Titan continues to own at least 50% of the shares originally issued to
     Titan. As of December 31, 1998, no royalties have been earned by Titan. On
     February 28, 1997, the Company and Titan executed an addendum to the
     License Agreement whereby the Company received a sole license to Titan's
     patent to develop and distribute products to the in-home consumer
     microcomputers market segment. Under this addendum, Titan waived all
     defaults previously incurred by Wave as well as extended the license
     agreement to expire at the time the patents expire.

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

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

                                      F-29
<PAGE>

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

             Notes to Consolidated Financial Statements, (Continued)

(12) Joint Venture

   In July of 1997, the Company entered into a joint venture with Internet

     Technology Group, PLC ("ITG"), a United Kingdom Internet service provider.
     The joint venture is owned 25% by the Company and 75% by ITG. The Company
     contributed its technical expertise and ITG contributed initial working
     capital and the commitment to fund all future working capital requirements
     of the joint venture. The objective of the joint venture company, Global
     Wave, Ltd., is to promote and commercialize the Wave technology in certain
     European and Middle Eastern markets. Pursuant to the joint venture
     agreement, the Company received a license fee of up to $5 million in
     exchange for the joint venture's right to market the Wave technology in
     European and Middle Eastern markets. The license fee was paid by ITG as
     part of its commitment to fund the joint venture. During the third quarter
     of 1997, the Company received $1.0 million from the joint venture
     representing partial payment of the license fee, with the remaining
     payments to be made upon the Company's attaining certain milestones related
     to the number of Wave Meters distributed. The amount received was recorded
     as deferred license fee income in the third quarter of 1997 as it was
     uncertain whether the Company had met the contractual requirements required
     in order to have earned the first payment. During the fourth quarter of
     1997, the Company met these requirements and began recognizing the license
     fee ratably over the contractual refund and recorded the $1 million as a
     license fee. Also the Company accrued $490,000 in the fourth quarter of
     1997 for expenses related to the Company's obligation to assist the joint
     venture in setting up the Wave system in the designated markets. In January
     1998, the joint venture agreement was modified to extend the milestone
     dates and provide for the payment of an additional $750,000 of the $5
     million license fee to the Company. The payment of $750,000 was received in
     January 1998. The Company also received the final payment of $3.25 million
     in June 1998 pursuant to the licensing and joint venture agreement ("the
     Agreement") with Internet Technology Group, PLC, a United Kingdom company.
     This payment and the $750,000 received in January 1998 total $4 million
     received in 1998. As part of the Agreement, after the final license fee is
     paid, the Company and Internet Technology Group, PLC are to issue a
     significant warrant to each other for approximately one million shares of
     each others common stock. The exercise price of the Wave warrants is $1.75
     per share. The exercise price of the ITG warrant is approximately .995
     British pound per share. On June 5, 1998, the final milestone for the last
     payment on the license fee was attained and the Company became obligated to
     issue its warrant to ITG pending approval by the shareholders of ITG for it
     to issue its reciprocal warrant. On this date the net fair market value of
     the exchange of warrants represented a net cost to the Company of
     approximately $1.1 million. The Company, upon determining this cost, has
     recorded the total amount as ITG net warrant cost in the Consolidated
     Statement of Operations.

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

   The Company  accounts for its 25% interest in the joint venture  pursuant to
     the equity method of  accounting.  At December 31, 1998 and 1997, the 
     Company's investment in the joint venture was $0 for financial reporting 
     purposes.

                                      F-30
<PAGE>

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

             Notes to Consolidated Financial Statements, (Continued)

(13) Commitments and Contingencies

   Litigation

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

    On June 27, 1997 a complaint alleging breach of contract, among other
     related claims, was filed against the Company by Carl A. Artopeous and
     Artopeous Capital Management (collectively, "Artopeous") with the
     Sacramento Superior Court in Sacramento, California in connection with the
     engagement of Artopeous by the Company to arrange financing. The action has
     been removed to the Federal Court, Eastern District of California. Wave
     filed its answer in December 1997 and agreed to a settlement on January 25,
     1999. The settlement cost of approximately, $602,000 and has been accrued
     in the December 31, 1998 financial statements.

  Leases

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

   The Company is obligated under a capital lease for a phone system in the Lee,
     Massachusetts office. At December 31, 1998 the gross amount of plant and
     equipment and related accumulated amortization recorded under capital
     leases were as follows:

<TABLE>
<CAPTION>
                                                           1998              1997
                                                           ----              ----
     <S>                                                 <C>               <C>     
     Phone Equipment                                     $111,291          $111,291
     Less: Accumulated Amortization                        33,387            11,129
                                                           ------           -------
     Ending Balance                                       $77,904          $100,162
                                                           ======           =======
</TABLE>

   Amortization of assets held under capital leases is included with
depreciation expense.

                                                                     (Continued)

                                      F-31
<PAGE>

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

             Notes to Consolidated Financial Statements, (Continued)

Future minimum lease payments under noncancelable operating leases (with initial
     or remaining lease terms in excess of one year) and future minimum capital
     lease payments as of December 31, 1998 are as follows:

<TABLE>
<CAPTION>

         Year ending December 31,                            Capital Lease       Operating Lease
                  <S>                                        <C>                   <C>     
                  1999                                       $ 42,372              $203,937
                  2000                                         21,186               162,604
                  2001                                              -               119,382
                                                                                    -------
         Total minimum lease payments                          63,558              $485,923
                                                                                    =======
         Less: interest                                        3,389
                                                              ------
         Present Value of net minimum
            lease payments                                    60,169
         Less: current installment of obligations
            under capital lease                               39,409
                                                              ------
         Obligation under capital lease
            excluding current installments                   $20,760
                                                              ======
</TABLE>

   Rent expense for the years ended  December 31, 1998,  1997,  1996 and for 
     the period from  inception  through  December 31, 1998  amounted to  
     approximately $307,000, $383,000, $341,000 and $1,800,000, respectively.

(14) Income Taxes

   The Company has net operating loss carryforwards for tax return purposes of
     approximately $47.6 million which expire beginning in 2003 through 2014.

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

   The tax effects of temporary differences that give rise to the deferred tax
asset at December 31, 1998 and 1997 are as follows:

<TABLE>
<CAPTION>
                                                                              1998                      1997
                                                                              ----                      ----
     <S>                                                                  <C>                       <C>        
     Deferred tax assets:
       Net operating loss carryforwards                                   $ 19,978,000              $15,493,000
       License rights                                                          980,000                1,307,000
                                                                            ----------               ----------
          Total gross deferred tax assets                                   20,958,000               16,800,000
       Less valuation allowance                                            (20,958,000)             (16,800,000)
                                                                           -----------               ----------

          Net deferred tax asset                                                 $  -                      $ - 
                                                                                   ===                      ===
</TABLE>

   The valuation allowance increased by approximately $4.2 million and $5.2
million, during the years ended December 31, 1998 and 1997, respectively.

                                      F-32

<PAGE>

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

             Notes to Consolidated Financial Statements, (Continued)


(15) Defined Contribution Plan

   The Company adopted the Wave Systems Corp. 401(k) Savings and Investment
     Plan, a defined contribution plan, to which substantially all employees can
     contribute on January 1, 1995. Employees of the Company become eligible
     immediately on employment. The Company has the option to make discretionary
     matching contributions; no contributions were made in 1998, 1997 or 1996.

(16) Disclosures about the Fair Value of Financial Instruments

   Cash and Cash Equivalents, Accounts Receivable, Accounts Payable and Accrued 
     Expenses, and Note Payable

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

   Limitations

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

(17) Subsequent Events

   During March of 1999, the Company raised approximately $23,000,000 through
     the private placement to institutional, strategic and accredited individual
     investors of approximately 2.1 million shares of Class A common stock at
     $11.00 per share.

   During January of 1999, the Company issued a non-interest bearing convertible
     promissory note for $2,000,000 to one (1) accredited investor. The note
     shall be due and payable on January 26, 2002 unless the company raises
     financing of at least $5,000,000, whereby the Company must repay the
     principal of the note within five business days of such financing, unless
     converted into Class A common stock of the Company. The note holder is
     entitled to 275,000 warrants to purchase Class A common stock at an
     exercise price of $4.00, and the warrants expire on January 26, 2004. If,
     over any sixty (60) consecutive day period, the average of the averaged
     daily high and low prices of the Class A Common Stock, as reported by
     Bloomberg Information Services, Inc., exceeds seven dollars ($7.00), the
     Company has the option to force the conversion of the Warrants. The fair
     value of such warrant will be recorded as interest expense through the
     earliest available conversion date of the note. In March 1999, subsequent
     to and in addition to the Company's completion of the $23 million private
     placement, the $2 million note was converted into 181,818 shares of the
     Company's Class A common stock at a conversion price of $11.00 a share.