UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-K

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|ý                                                                | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|---------------------------------------------------------------- | ----------------------------------------------------------------------------------------
|For the fiscal year ended December 31, 2007                     
|o                                                                | 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(State or other jurisdiction of
incorporation or organization)         |  | 13-3477246(I.R.S. Employer
Identification No.)
|------------------------------------------------------------------------------ |  | ----------------------------------------------
|480 Pleasant Street
Lee, Massachusetts(Address of principal executive offices) |  | 01238(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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act. YES o    NO ý

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

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 ý    NO o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405) 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. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting
company. See definition of "accelerated filer", "large accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one).

|Large accelerated filer o                                             |  | Accelerated filer ý        
|--------------------------------------------------------------------- |  | ---------------------------
|Non-accelerated filer o (Do not check if a smaller reporting company) |  | Smaller reporting company o

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

The aggregate market value of the shares of Common Stock of the registrant held by non-affiliates based on the closing price (as reported by NASDAQ) of
such common stock on the last business day of the registrant's most recently completed second fiscal quarter (June 30, 2007) was approximately $103 million. (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, 2008 there were 52,917,827 shares of the registrant's Class A Common Stock and 38,232 shares of the registrant's Class B Common Stock outstanding.

DOCUMENTS
INCORPORATED BY REFERENCE:

Portions
of our definitive Proxy Statement for the 2008 Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A on or before April 30, 2008, have been
incorporated by reference into Part III of this annual report.



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EXCEPT FOR HISTORICAL INFORMATION CONTAINED HEREIN, THIS FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE U.S. SECURITIES LITIGATION REFORM ACT
OF 1995. THESE STATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES THAT MAY CAUSE WAVE'S ACTUAL RESULTS OR OUTCOMES TO BE MATERIALLY DIFFERENT FROM THOSE ANTICIPATED AND DISCUSSED
HEREIN. FURTHER, WAVE OPERATES IN AN INDUSTRY SECTOR WHERE SECURITIES VALUES MAY BE VOLATILE AND MAY BE INFLUENCED BY REGULATORY AND OTHER FACTORS BEYOND WAVE'S CONTROL. IMPORTANT FACTORS THAT WAVE
BELIEVES MIGHT CAUSE SUCH DIFFERENCES ARE DISCUSSED IN THE CAUTIONARY STATEMENTS ACCOMPANYING THE FORWARD-LOOKING STATEMENTS AND IN THE RISK FACTORS DETAILED IN PART I, ITEM 1 OF THIS
FORM 10-K 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.

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Table of Contents

|PART I   |          | 2 
|-------- | -------- | --
|         | Item 1.  |   
|         | Item 1A. |   
|         | Item 1B. |   
|         | Item 2.  |   
|         | Item 3.  |   
|         | Item 4.  |   
|PART II  |          | 22
|         | Item 5.  |   
|         | Item 6.  |   
|         | Item 7.  |   
|         | Item 7A. |   
|         | Item 8.  |   
|         | Item 9.  |   
|         | Item 9A. |   
|         | Item 9B. |   
|PART III |          | 44
|         | Item 10. |   
|         | Item 11. |   
|         | Item 12. |   
|         | Item 13. |   
|         | Item 14. |   
|PART IV  |          | 45
|         | Item 15. |   

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PART I

Item 1.    Business

Wave Systems Corp. develops, produces and markets products for hardware-based digital security, including security applications and services that are
complementary to and work with the specifications of the Trusted Computing Group,www.trustedcomputinggroup.org("TCG"). Specifications developed by the
TCG are designed to address a broad range of current and evolving digital security issues. These issues include: identity protection, data security, digital signatures, electronic transaction
integrity, platform trustworthiness, network security and regulatory compliance.

The
TCG is an industry standards body, comprised of computer and device manufacturers, software vendors and others, whose purpose is to develop, define and promote open industry standard
specifications for embedded hardware-enabled computing products, including security technologies across multiple platforms, peripherals and devices. The current TCG specification recommends a
hardware-based trusted computing platform, which is a platform that uses a semiconductor device, known as a Trusted Platform Module ("TPM") that performs protected activities, including protected
storage, platform authentication, protected cryptographic processes and attestable state capabilities to provide the first level of trust for the computing platform (a "Trusted Platform"). The TPM is
a hardware chip that is separate from the platform's main CPU(s) that enables secure protection of files and other digital secrets, and performs critical security functions such as generating, storing
and protecting "cryptographic keys," which are secret codes used to decipher encrypted or coded data. While TPMs provide the anchor for hardware security, known as the "root of trust", trust is
achieved by integrating the TPM within a carefully architected trust infrastructure and supporting the TPM with essential operational and lifecycle services; such as key management and credential
authentication.

Prior
to the formation of the TCG, Wave developed its pioneering EMBASSY (EMBedded Application
Security SYstem) Trust System. The EMBASSY Trust System is a combination of client hardware consisting of the EMBASSY 2100 security chip (the
"EMBASSY chip"); and software consisting of the
Trust Assurance Network ("TAN"), a back-office infrastructure that manages its security functions. As the market for TPM-enabled products has developed with computing devices
being shipped in volume by leaders in the PC industry, Wave has enabled the development work on the EMBASSY Trust System to support security hardware based on the TCG specifications, by repurposing
these product assets. Wave has since developed a set of applications known as the EMBASSY Trust Suite, EMBASSY Trust Server products, middleware and software tools to work with various other chip
manufacturers' TCG-enabled TPMs that are now available. Wave's products are unique in the fact that they support cross platform interoperability for the currently available TPM
chips from Winbond Electronics Corporation ("Winbond"), Atmel, Broadcom, Infineon Technologies AG, and ST Microelectronics and have been verified for usage on TPM platforms shipped by Intel, IBM, HP,
NEC, Fujitsu, Gateway (acquired by MPC) and Dell.

In
addition, in 2007 Wave introduced software to support the newest trusted component, the Seagate Momentus 5400.2 FDE (Full Disc Encryption) drives for hardware protection of data.
Wave's products supporting FDE drives include the EMBASSY Trusted Drive Manager (ETDM) and the EMBASSY Remote Administration Server (ERAS). The Trusted Drive Manager was developed in partnership with
Seagate. During 2007, Wave announced a licensing agreement with Seagate for bundling and joint marketing of a Seagate version of the EMBASSY Trust Suite with Seagate FDE drives in certain distribution
channels. Also during 2007, Wave and Seagate announced that their data protection solution was being offered by Dell, ASI, and NEC Europe.

Wave's
operations to date have consisted primarily of product development, performance under contract to develop products and marketing and initial sales to personal computer ("PC") and
semi-conductor chip ("Chip") original equipment manufacturers ("OEMs"), resellers, and enterprises.

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In
addition, Wave has signed distribution contracts for its products with a number of OEMs that have resulted in a marked increase in revenues for the year ended December 31, 2007 versus
prior years.

Wave
has been successful in signing distribution contracts with Intel, Winbond, ST Microelectronics, Dell Products LP, Gateway/MPC and Broadcom. However, due to the early stage
nature of its market category, Wave is unable to predict with a high enough level of certainty whether enough revenue will be generated in calendar 2008 to fund its cash flow requirements. Given the
uncertainty with respect to Wave's revenue forecast for 2008, it is likely that Wave will be required to raise additional capital through either equity or debt financing in order to adequately fund
its capital requirements for the year ending December 31, 2008. As of December 31, 2007, we had working capital of approximately $1.7 million. On February 29, 2008, Wave
entered into subscription agreements with certain purchasers, pursuant to which Wave agreed to sell and issue 3,173,500 shares of its Class A common stock, par value $.01 per share, to such
purchasers for an aggregate purchase price of $3,490,850. These shares were priced at $1.10 per share. Wave also agreed to issue warrants to the purchasers to purchase up to 952,050 shares of
Class A common stock at an exercise price of $1.15 per share. These warrants expire in February 2013. Securities Research Associates, Inc. ("SRA") entered into a placement agency
agreement with Wave in which they agreed to act as placement agent in connection with this offering. Wave agreed to pay SRA a fee equal to 6.0% of the gross proceeds of this offering. Additionally,
Wave agreed to issue a warrant to SRA to purchase up to 190,410 shares of Class A common stock at an exercise price of $1.33 per share. This
warrant has an eighteen month term and may not be exercised before the 180th day of its term. Wave realized net proceeds of approximately $3,221,000 after deducting the placement
agent fees of $209,451 and additional legal and other fees associated with the issuance of these securities, which totaled approximately $60,000. The shares sold on February 29, 2008 were
offered and issued pursuant to a shelf registration statement on Form S-3 which was filed by Wave on March 20, 2007 and declared effective by the Commission on
April 27, 2007. Considering our current cash balance (including the net proceeds from our February 29, 2008 financing described above) and Wave's projected operating cash requirements,
we anticipate that we will need a minimum of approximately $12.7 million of additional cash to satisfy our current forecasted cash flow requirements for the year ending December 31,
2008. Due to our current cash position, our capital needs over the next year and beyond, the fact that we will require additional financing and uncertainty as to whether we will achieve our sales
forecast for our products and services, substantial doubt exists with respect to our ability to continue as a going concern.

Formation of the Trusted Computing Group and introduction of TCG Compliant Products

The TCG was formed in April, 2003. The Promoting Founders were AMD, HP, IBM, Intel, and Microsoft. Wave Systems was invited to join the founding group as a
Contributing Member. Upon its inception, the TCG formally accepted the initial technical specifications developed by the Trusted Computing Platform Alliance ("TCPA") for Trusted Platform Modules
Version 1.1 and formally superseded the TCPA organization. The TCG has significantly expanded the industry participation in security hardware standards and now includes industry leaders offering
additional platforms such as storage devices, cell phones, PDAs and consumer electronics. During 2003, several manufacturers of semiconductors for the PC industry, including National Semiconductor,
Atmel and Infineon, were offering products capable of functioning as TPMs meeting the TCG TPM Version 1.1 standard for trusted computing. In addition, PC platforms that included
TPMs were announced and/or available from IBM, Intel, and HP. In 2004, the rate of adoption of TPMs accelerated with additional platforms announced by the major OEMs that were
already shipping platforms and an additional OEM, Fujitsu, announced products with TPM's. In 2005 through 2007, the rate of adoption of TPMs continued to grow with the availability of
TPM-equipped PCs and servers from additional PC OEMs including Dell, Gateway/MPC and Lenovo. The overall number of TPM-equipped PC models being offered from the
OEMs shipping with TPMs, combined with the increased number of OEMs that have introduced TPM-equipped models, has continued to accelerate the rate at which TPMs are
being shipped by the PC industry. In 2005, the TCG released a new version of the TPM specification, Version 1.2, which

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includes
a number of enhancements and extensions over the Version 1.1b. TPM Version 1.2 is fully backwards compatible to Version 1.1b, which provides a smooth transition for deployment of the
TPM technology and increases the TPM functionality. In addition, vendors such as Atmel announced TPM products targeted to support embedded systems applications beyond the
traditional PC market. There are also TCG Working Groups that are developing specifications to extend TCG technologies to other devices such as storage devices, network products, servers, peripherals
and mobile devices.

The
offering of products using TCG specifications to the PC market is an important development in the creation of the market for hardware-based computer security. Wave has begun
executing a strategy
to leverage its EMBASSY Trust System in an effort to become a leading developer of software, applications and services for this market. Wave is providing solutions in the market that are designed to
work with many commercially available products using TCG specifications.

Products and Services

Client-side Applications

The EMBASSY Trust Suite

The current version of the EMBASSY Trust Suite is a set of applications and services that are designed to bring functionality and user value to
TPM-enabled products. Designed to make the TPM easy for users to set up and use, the EMBASSY Trust Suite includes the EMBASSY Security Center (the "ESC"), Trusted Drive Manager ("TDM"),
Document Manager ("DM"), Private Information Manager ("PIM") and Key Transfer Manager ("KTM").

The
ESC enables the user to set up and configure the TPM platform. In addition to the basic function of making the TPM operational, ESC is designed to enable the user to manage extended
TPM-based security settings and policies, including strong authentication, Windows logon preferences to add biometrics and streamlined password policy management. In March 2007, Wave
announced a new version of the ESC software that supports Seagate's Momentus 5400 FDE.2 hard drive, the latest version of Seagate's FDE drives (the "Seagate Trusted Drives"). Wave's EMBASSY Trust
Suite software for TPM and key management also supports Seagate Trusted Drives.

Data
Protection is addressed by the DM, which provides document encryption, decryption and client side storage of documents. The DM, which works with Microsoft Windows, and Microsoft
Office, secures documents against unauthorized users and hackers. In early 2007, Wave announced support for Microsoft's new Windows Vista operating system and compatibility with Wave's latest version
of its EMBASSY Trust Suite software. Wave's software is Windows Vista ready and builds upon the new operating system's data protection feature set, providing full-featured EMBASSY
solutions for data protection and strong authentication.

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

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

Additionally,
Wave has developed TPM Wizards as part of the EMBASSY Trust Suite which allow users to setup and use the TPM for securing 802.11x wireless networks, the Windows Encrypting
File System and encrypted email.

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Wave
plans to continue to develop and enhance the current products being developed within this product group and to develop new applications and services as the trusted computing market
continues to evolve. Current planned development costs for this product group are expected to be approximately $3.3 million for the year ending December 31, 2008.

Middleware and Tools

TCG-Enabled Toolkit

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

Wave TCG-Enabled Cryptographic Service Provider ("CSP")

Wave offers a TCG-enabled CSP, which allows software developers to utilize the enhanced security of a TCG standards-based platform, facilitating a
common user experience independent of the platform. It also enables applications to utilize functionality available on TCG-compliant platforms directly through the Microsoft cryptographic
application programming interface, without requiring user knowledge of any specific TCG software stack layer.

Current
planned development costs for this product group are expected to be approximately $4.6 million for the year ending December 31, 2008.

EMBASSY Trust Server Applications

EMBASSY Key Management Server ("EKMS")

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

EMBASSY Authentication Server ("EAS")

EAS provides centralized management, provisioning and enforcement of multifactor domain access policies. With EAS, authentication policies can be based on TPM
credentials, Smart Card credentials, user passwords and fingerprint templates. With EAS, authentication policies can be provisioned and
managed from the domain controller. EAS has an integrated biometric template capability with support for a variety of third-party vendors.

EMBASSY Remote Administration Server ("ERAS")

ERAS is a server product that provides centralized management and auditing of Trusted Platform Modules ("TPM") and Seagate Trusted Hard Drives ("Trusted Drive").
ERAS is designed to give IT administrators the ability to deploy and remotely manage Trusted Drives and TPM systems. It provides for initialization, pre-boot authentication
management, recovery, and repurposing of TPMs and Trusted Drives. ERAS is designed to provide auditing capabilities that aid in compliance management by allowing for validation of TPM and
Trusted Drive security settings, thus allowing

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IT administrators
to assess the risk of whether a lost or compromised PC is adequately secure. ERAS is designed to facilitate enterprise adoption of TPM and Trusted Drive
technology as it provides IT administrators with tools to utilize the security of these devices while reducing deployment and management costs.

Current
planned development costs for this product are expected to be approximately $1.6 million for the year ending December 31, 2008.

Digital Signature and Electronic Document Management

On October 4, 2001, Wave acquired the digital signature and electronic document management technology, SmartSignature and SmartSAFE, from
SignOnLine, Inc. ("SignOnLine"), a California-based company. This group of products initially made up our eSign Transaction Management Suite, also known as eTMS ("eTMS"), which consisted of
four core products: SmartIdentity, SmartSignature, SmartSAFE and SmartConnect. SmartSignature Version 3.0 is a digital signature application that connects signers and institutionsbanks,
insurance companies, enterprises, etc.through a legally binding digital signature. Wave's SmartSignature Server, a server-side electronic signature application, enables
individuals to electronically sign and store virtually any format of document, while connected to a server, as opposed to the signing taking place on the client PC. During the fourth quarter of 2007,
Wave launched SmartSigning Rooms Version 1.0, which enhances the functionality of the SmartSAFE to enable an organization to offer signers a secure virtual environment to review, annotate and
electronically sign documents.

To
increase the security associated with identity protection and digital signing credentials, Wave's SmartSignature is currently enabled for the support of TPMs. SmartSAFE Version
4.0 is a web-based document management application where signed documents are archived and tracked. SmartSAFE provides an easy to use environment where a client institution can view,
manage, store and transfer sensitive signed and unsigned documents. SmartSAFE also supports archival and management of unsigned documents in virtually any format. These products allow a document to be
executed, verified, accepted and filed in minutes at a lower cost compared to traditional paper-based documentation methods. SmartSignature Version 3.0 and SmartSAFE Version 4.0 have been completed
and Wave commercially released these products in the first quarter of 2007. SmartIdentity, an optional service to verify a signer's identity through strong authentication methods, including issuing
encrypted digital certificates based on public key infrastructure technology, was completed and released in January of 2003. Wave will continue to allocate resources toward marketing and sales to
promote these products.

Wave's
eTMS, in addition to supporting TPMs, is also being independently marketed in the insurance, mortgage, banking, government and other markets which are seeking digital and
electronic signature solutions that are compliant with the Electronic Signatures in Global and National Commerce Act ("ESIGN"). eTMS' SmartSignature Server product was licensed to a la
mode, Inc., a leading provider of desktop, mobile, and Web tools for the real estate and mortgage industries, to provide digital signature solutions for their XSites product line. Wave also
signed a licensing agreement in 2005 with Efficient Forms, LLC, a leading provider of interview-based electronic forms creation, to offer a comprehensive managed-service solution for electronic
forms and electronic signatures. Over the past 24 months, through direct and reseller channels, over 3,000 organizations have used eTMS functionality to automate paper processes. Some of the
flagship organizations that are currently utilizing eTMS include: Ellie Mae, Realtime Solutions Group, Heritage Union, DocuTech, Remark, American Community Life Insurance Company, Trust Company of
America, Digital Docs, Compliance Source and others. Wave has focused on digital signature applications that can make effective use of the stronger security features provided by trusted computing
platforms.

Current
planned development costs for this product are expected to be approximately $300,000 for the year ending December 31, 2008.

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Broadband Media Distribution Services

Wave offers broadband content distribution products and services through Wavexpress, a joint venture between Wave and Sarnoff Corporation. The joint venture was
established on October 15, 1999. Under the joint venture agreement, Sarnoff and its affiliates initially received a 40% equity stake in Wavexpress. Wave initially received a 53% equity interest
and its affiliates, who purchased founders stock in April 1999 for a nominal amount, owned the remaining 7% of the outstanding capital stock.
As of December 31, 2007, Wave owned 69% of Wavexpress, while Sarnoff owned 25.6%. The affiliates of Wave include Peter Sprague, former Chairman of Wave, Steven Sprague, Chief Executive Officer
of Wave, certain members of the Board of Directors of Wave and certain Wave employees.

Wavexpress
has developed a vertically integrated suite of products designed to enable the optimum broadband distribution of digital programming. The current product offering combines
industry standard syndication protocols with proprietary back-end software to create an end-to-end content syndication and monetization platform. This system is
offered to content providers looking to deliver high-quality broadband media services using either Wavexpress' distribution facility or on their own, through Really Simple Syndication
("RSS"). RSS is the standard format for blogs and podcasts and is being increasingly used for open video distribution on the Internet. Content providers connect through the Wavexpress client and
backend software to generate advertising revenue or subscription fees for premium services. Wavexpress' business model intends to derive revenue either from direct fees charged to content providers
for the use of Wavexpress software and facilities, or from a share of advertising proceeds collected. Wavexpress proprietary client software is integrated and promoted through Microsoft's XP Media
Center Edition operating system, as well as the Vista Premium and Vista Ultimate operating systems which began shipping in January 2007. It is also available through Microsoft's Internet Explorer web
browser.

We
believe Wavexpress' products deliver value to content providers by bringing a traditional advertising sales model to the emerging market for cached, syndicated,
high-quality video content. By leveraging an open standard, RSS, Wavexpress believes it is in a position to work with any content providerlarge or small. Wavexpress'
investment in proprietary backend and distribution technology creates opportunities to differentiate and capitalize on this rapidly growing segment of the content industry.

Planned
future development expenditures are expected to approximate $1.6 million for the year ending December 31, 2008.

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

Although
Wave's revenue has grown considerably in 2007 versus prior years, Wave's revenue in 2007 of approximately $6,307,000 was significantly below operating expenses, which were
approximately $25,781,000. For the years ended December 31, 2007, 2006, and 2005, Wave incurred losses to common shareholders of approximately $19,952,000, $18,785,000 and $17,562,000
respectively. At December 31, 2007, we had an accumulated deficit of approximately $323,484,000. There can be no assurance that we will ever be successful in achieving commercial acceptance of
our products and services.

Markets and Business Strategy

Our Market

Software has traditionally secured critical information on networks and PCs and allowed for user access to various applications. However, virus attacks and
breaches of security have proven that software, on its own, is not capable of completely securing a network or platform. Because of these

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persistent
security concerns, we believe that there is now a recognized need in the computer industry for the development and deployment of a more robust and reliable security infrastructure including
new security hardware in devices to guard against these persistent security risks. The TCG was formed to develop, define and promote open industry standard specifications for embedded hardware-enabled
trusted computing and security technologies, including secure hardware and software interfaces across multiple platforms, peripherals and devices. The underlying premise of the creation of a Trusted
Platform that meets the TCG specification is that only when a platform is secured by hardware, in effect creating a root of trust and an authenticatable security environment within the computer
itself, will the information stored on the platform be adequately secure. Wave is seeking to become a software, application and services leader in hardware-based digital security and
e-commerce products markets. Because Wave has been a pioneer in developing hardware-based computer security systems, we believe we are distinctively positioned to take advantage of our
unique knowledge, significant technology assets and trusted computing intellectual properties.

Hardware-based
trusted computing solutions involve a new approach to conducting business and exchanging information using computer systems. We believe that these solutions will require
traditional software-based security to be augmented with next generation hardware-based security and an enhanced support infrastructure. Intensive marketing and sales efforts have been, and will
continue to be, necessary, in order to generate demand for products using Wave's technology, and to ensure that Wave's solution is accepted in this emerging market. Our objective is to make our
EMBASSY branded products and services the preferred applications and infrastructure for Trusted Platforms. Key components in achieving this goal include:

Capitalizing on Information Security Industry Trends

We believe that security remains one of the top industry priorities across multiple segments of the user and product value chains. Wave believes that a key
differentiator of its EMBASSY Trust Suite is that it
is interoperable across all of the currently available TPM-enabled Windows platforms and provides for ease of use. Key industry initiatives and security specifications that will require
the addition of trusted hardware are moving forward in a number of platforms including Microsoft's Windows Vista operating system, Intel's LaGrande secure computing program, and AMD's Secure Execution
Mode ("SEM"). Similar programs are under consideration in network devices, and mobile devices such as PDAs and cell phones and consumer electronics devices.

Wave
has designed its products with features and functionality that we believe uniquely positions us to capitalize on information security industry issues and trends. Wave believes that
the following could be important issues and trends for our strategic objectives:



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Wave
will continue to pursue strategic relationships with hardware manufacturers, independent software vendors, systems integrators and companies involved in the development of commerce
in electronic content and services to achieve broad market acceptance of its products as a platform for security solutions and commerce performed in user devices.

Pursue Strategic Marketing and Distribution Alliances

We intend to expand Wave's strategic alliances with key partners that could distribute our products in enterprise, government and eventually consumer markets, and
to build upon our alliances with such industry leaders as Intel, Dell, HP, IBM, Lenovo, NEC, Gateway/MPC and others in the PC industry. In addition, we are engaged in strategic activities with
semi-conductor manufacturers Broadcom, ST Microelectronics, Winbond, Atmel and Infineon Technologies to support and/or deploy EMBASSY applications with their TPMs designed to
the TCG specifications. TCG has expanded its scope to include networking systems, trusted peripherals, data storage devices, mobile wireless products and consumer electronics devices. Wave anticipates
additional secure storage devices and data protection alternatives, similar to the Seagate FDE drives, will be introduced in 2008 and thereafter and that these products could be supported by our
trusted drive solutions. Wave believes its trusted computing offerings can provide significant value in these new markets and on these platforms and thus, is working to establish relationships with
key partners in each of these markets.

Enhancing Our Current Product Offerings and Products in Development

We intend to continue to develop and extend our existing product offerings to include features and functionality to meet customer requirements and market demand.
Planned development efforts that
enhance or utilize existing technologies include building upon and enhancing our EMBASSY Trust Suite, eTMS applications and Wavexpress broadband media distribution software applications.

Client
and server solutions supporting both the operations and life cycle management of Trusted Platforms is a major focus area for Wave. New products that Wave is planning on developing
over the ensuing period will consist primarily of new TCG client and server software services and enabling tools that will expand upon its portfolio of TCG trusted computing applications and services
in the following areas:



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These
development efforts will likely be significant and Wave intends to expend a substantial portion of its research and development resources towards these enhancements as well as
significant marketing and corporate development funds to introduce the products and build market demand. As a result, our continued research and development efforts will require substantial capital
resources, which will likely necessitate the need for further funding so that Wave may ultimately be able to capitalize on the emerging market opportunities for its products and services. Wave
announced major products in 2007, primarily for server-based products, and is developing significant new client and server-based products
and product enhancements, which are planned to be introduced in 2008. For example: At the 2007 Interop Conference, in May 2007, Wave demonstrated its endpoint integrity software solution integrated
with Microsoft Network Access Protection. Wave is also working closely with Juniper Networks on its Unified Access Control solution. Wave's EMBASSY software, combined with the industry-standard TPM
hardware security chip, is designed to complement the Juniper and Microsoft solutions by offering a tamper resistant and secure machine identity and TPM-signed and secure integrity checks
in conjunction with their access control agents. Network access control systems are designed to enforce security policy and restricting prohibited platform configurations on the network; identify and
contain platforms that are noncompliant with policy; and address malware and root kits before they touch the network.

Marketing, Sales and Customers

Because Wave's products involve a new approach to conducting business and exchanging information using computer systems, we believe market acceptance of these
products will require that traditional software-based security be enhanced and/or replaced with next generation products designed using the TCG and related specifications. Intensive marketing and
sales efforts have been and will continue to be necessary in order to increase recognition of and generate demand for products using Wave's technology and to ensure that Wave's solutions are accepted
in this emerging market. Our current primary focus is on closing business with chip OEMs, PC OEMs, enterprise customers and systems integrators. Wave has also undertaken steps to develop and establish
a reseller channel for our products.

Wave's
business model targets revenues from various sources: licensing of our technology including EMBASSY Trust Suite client applications; tools and enabling software; and client/server
based trusted software solutions for the lifecycle management of keys and authentication of Trusted Platforms.

Wave
has identified six key markets where we believe our products could provide unique benefits:



10

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

Wave's
sales for the year ended December 31, 2007 consisted primarily of licensing its software applications, engineering and support services. Of the total revenue realized for
the year ended December 31, 2007, 100% was derived from Wave's EMBASSY computer security products and services. For the year ended December 31, 2006, 99% was derived from Wave's EMBASSY
computer security products and services and 1% was from Wavexpress' broadband media distribution segment. For the year ended December 31, 2005, 96% was derived from Wave's EMBASSY computer
security products and services and 4% was from Wavexpress' broadband media distribution segment. Customers from which Wave derived revenue in 2007 in excess of 10% or total revenues that would have a
material adverse effect on Wave's business if Wave were to lose such customers are as follows:

|Customer   |  | Product or Service Sold |  | Percentage of Total Revenue for the year ended December 31, 2007 |  
|---------- |  | ----------------------- |  | ---------------------------------------------------------------- | -
|Dell, Inc. |  | Software Licensing      |  | 71                                                               | %
|Broadcom   |  | Software Licensing      |  | 11                                                               | %

Wave's
business plan, will continue to depend heavily on a small number of OEM customers, partners and prospective customers, the loss of, or lack of substantial future revenues from any
of whom, may have a material adverse effect on our business plan going forward. These include Dell, Inc. and Broadcom. However, in 2007, Wave expanded its presence as a security solutions
provider marketing to small, medium and large business enterprises and will continue to aggressively market its products and services to these enterprises in concert with its OEM customer base.

Segment Reporting

Information required by this item is incorporated herein by reference to "Segment Information" in Note 15 of the Notes to Consolidated Financial
Statements.

11

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Financial Information about Geographic Areas

Information required by this item is incorporated herein by reference to "Segment Information" in Note 15 of the Notes to Consolidated Financial
Statements.

Competition

Wave EMBASSY Digital Security Products

We operate in the information security market, a highly competitive and fragmented environment that is characterized by rapidly evolving technology. Many of our
competitors and potential competitors have substantially greater financial, technical and marketing resources than us. Also, many current and potential competitors have greater name recognition and
more extensive customer bases to leverage, allowing these competitors to gain market share or product acceptance to our detriment. In addition, the rate of market acceptance of trusted computing
solutions is still in the formative and early stages, despite the substantial increase in distribution of the technology. The markets for our products are developing and, while the TCG specifications
have provided the basis for the industry to move forward, there remains significant standards work efforts in order for the eco-system supporting trusted computing to move forward. Wave's
potential competitors include security solutions providers such as RSA Security, Inc. (a division of EMC), Symantec, Computer Associates, Verisign, Inc., Entrust, Inc., Utimaco,
Safenet and major systems integrators such as IBM, HP and EDS. In addition, Wave competes with other client security applications companies that are developing trusted computer applications including
Softex, Phoenix, Infineon and Microsoft. The competitive factors defining these evolving markets include product features, compatibility, standards compliance, quality and reliability, ease of use,
performance, customer service and support, distribution and price. Wave believes its products meet the requirements to be successful viable products in these markets. The features of Wave's products
that should allow it to compete favorably through product differentiation include: cross-platform, interoperable solutions; easy-to-use features; and leading edge trusted
client/server infrastructure solutions. In addition, Wave continues to have leading solutions with its digital signature products, especially when combined with trusted computing platforms and
features.

In
the market for data protection products there is a well established set of software companies which provide software based full disk encryption products and supporting infrastructure.
These are companies such as PointSec (acquired by Checkpoint), Ultimaco, Credant, PGP, SafeBoot, Secude (acquired by McAfee), Guardian Edge and others. As the markets for hardware-based full disk
encryption products evolves, it is likely that these companies will also provide support for the new trusted drives, similar to Wave's products which support these products today.

One
of the market challenges facing Wave is the establishment of a newly defined market category within the overall information security market for trusted computing software and
services that includes a more complex business model for adoption. While the TCG specifications define a very complex and comprehensive cryptographic system that require significant skills and
resources, the market for security solutions that are as complex as those developed by Wave is in a formative stage of development. As a result, commercialization of these technologies has been slow
to develop. It is also possible for other competitors to develop similar offerings to compete with our products or new technologies may emerge that could replace existing technology that our products
rely on, thereby making our products non-competitive or obsolete. We can offer no assurances that Wave's products will become industry standards or become widely accepted by the
marketplace.

Wavexpress Broadband Media Distribution

Wavexpress competes in a market dominated by traditional content delivery methods. Wavexpress prospects rely on traditional broadcast television, Internet
streaming and online websites. Wavexpress' technology augments these services by providing both content providers and viewers a television-like

12

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viewing
experience of Internet video using the Microsoft Media Center platform. Several companies compete for the delivery of television over broadband, including startup video networks such as
Akimbo, Joost and Veoh and streaming service providers such as YouTube and Brightcove.

International Market

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

We
believe the export classifications that we have received for our software products allow us to sell our products internationally in an effective, competitively advantageous manner.
Enhancements to existing products may, and new products will be subject to reviews by the BXA to determine what export classification they will receive. Some of our partners demand that our products
be allowed to be exported without restrictions and/or reporting requirements. Current export regulations have, in part, allowed us to receive the desired classification without undue cost or effort.
However, the export regulations may be modified at any time. Modifications to the export regulations could prevent us from exporting our existing and future products in an unrestricted manner without
a license, as we are currently allowed for the products that we've received classification, or make it more difficult to receive the desired classification. If export regulations were to be modified
in such a way, we may be put at a competitive disadvantage with respect to selling our products internationally.

Proprietary Rights and Licenses and Intellectual Property

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

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

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

We
also rely on copyright law to prevent the unauthorized duplication of our software and hardware products. We have and will continue to protect our software and our copyright interest
therein through agreements with our consultants. We can provide no assurance that copyright laws will adequately protect our technology.

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Research and Development

Wave's products incorporate encryption/decryption, client and server software applications and other technologies in which we have made a substantial investment
in research and development. We will likely be required to continue to make substantial investments in the design of information security applications and services, including the EMBASSY Trust Suite,
EMBASSY Server applications, eTMS products, and broadband media distribution products. For the years ended December 31, 2007, 2006 and 2005, we spent approximately $10.6 million,
$8.5 million and $6.9 million, respectively, on research and development ("R&D") activities. Planned development expenditures for the year ended December 31, 2008 are expected to
be approximately $11.1 million.

Employees

As of December 31, 2007, we employed one hundred seventeen (117) full-time employees, fifty-two (52) of whom were
involved in sales, marketing and administration and sixty-five (65) of whom were involved in research and development (including fourteen (14) employed by Wavexpress, three
(3) of whom were in sales, marketing and administration and eleven (11) of whom were involved in research and development). As of December 31, 2007, we retained the services of
seven (7) full-time consultants. We believe our employee relations are satisfactory.

Available Information

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

The public may read and copy any materials the Company files with the SEC at the SEC's Public Reference Room at 100 F Street, N.E., Washington, DC 20549.
Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site that
contains reports, proxies and information statements, and other information regarding issuers that file electronically with the SEC athttp://www.sec.gov.

Item 1A.    Risk Factors

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

We
have experienced significant losses and negative cash flow from operations since our inception. We have not realized a net operating profit in any quarter since we began our
operations. Wave's revenue in 2007 was significantly below operating expenses, as our products have not yet attained widespread commercial acceptance. This is due in part to the early stage nature of
the digital security industry in which we operate. As of December 31, 2007, we had an accumulated deficit of approximately $323.5 million and working capital of approximately
$1.7 million. Given the lack of widespread adoption of the technology for our products and services, there is little basis for evaluating the financial viability of our business and our
long-term prospects. You should consider our prospects in light of the risks, expenses and difficulties that companies in their early stage of development encounter, particularly companies
in new and rapidly evolving markets, such as digital security and online commerce.

14

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To
achieve profitability we must, among other things:



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

We may not be able to fund our operations and continue as a going concern.

Since
we began our operations, we have incurred net losses and experienced significant negative cash flow from operations. This is due to the early stage nature of market development for
our products and services and the digital security industry as a whole. Wave expects to continue to incur substantial additional expenses associated with continued research and development and
business development activities that will be necessary to commercialize our technology. This will likely result in significant losses for the foreseeable future. Considering our current cash balance,
which includes the net proceeds received from the financing transaction completed on February 29, 2008, and Wave's projected operating cash requirements, we anticipate that our existing capital
resources will be adequate to satisfy our cash flow requirements into June 2008. In order to fund our business into June 2008 and beyond, it will be necessary for us to generate
substantial revenue, complete one or more commercial or strategic transactions or raise additional capital. Wave is uncertain as to the availability of financing from other sources to fund any cash
deficiencies. Even if we are successful in raising additional capital, uncertainty with respect to Wave's viability will continue until we are successful in achieving our objectives. Furthermore,
although we may be successful at achieving our business objectives, a positive cash flow from operations may not ultimately be realized unless we are able to sell our products and services at a
profit. Given the early stage nature of the markets for our products and services, considerable uncertainty exists as to whether or not Wave's business model is viable.

We may be unable to raise the $12.7 million of additional cash flow, which is necessary to continue as a going concern for the next twelve
months.

Based
upon our current expense forecast, assuming current revenue levels, and taking into account the financing completed in February 2008, we estimate that our current available capital
is sufficient to fund Wave into June 2008. In addition to our efforts to begin to generate revenue sufficient to fund our operations, or complete one or more commercial or strategic transactions, Wave
is evaluating additional financing options to generate additional capital in order to continue as a going concern, to capitalize on business opportunities and market conditions and to insure the
continued development of our technology, products and services. We estimate, based upon our current forecasts, we will need to

15

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generate
a minimum of $12.7 million from a combination of revenue growth, commercial or strategic transactions and/or additional financings, to continue as a going concern for the twelve months
ended December 31, 2008. We expect we will be required to generate a significant portion of this cash through additional financings in the form of sales of newly issued securities. And while we
recently completed a financing in the form of sales of newly issued securities on February 29, 2008, we do not know if additional financing will be available or that, if available, it will be
available on favorable terms. As we issue additional shares of our stock, our stockholders' ownership will be diluted. Also, the shares issued may have rights, preferences or privileges senior to
those of our common stock. In addition, if we pursue debt financing we may be required to pay interest costs. The failure to generate sufficient cash flow to fund our forecasted expenditures would
require us to reduce our cash burn rate which would in turn impede our ability to achieve our business objectives. Furthermore, if we are not successful in generating sufficient cash flow or obtaining
additional funding, we will be unable to continue our operations, develop or enhance our products, take advantage of future opportunities, respond to competitive pressures and continue as a going
concern.

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

The
market for our products and services is still developing and is continually evolving. As a result, substantial uncertainty exists with respect to the size of the market for these
products and the level of capital that will be required to meet the evolving technical requirements of the marketplace.

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

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

Wave is not established in the industry so we may not be accepted as a supplier or service provider to the market.

Wave's
offering represents a highly complex architecture designed to solve many of the security issues currently present with computer systems, such as identity theft, fraudulent
transactions, virus attacks, unauthorized access to restricted networks and other security problems that users of computer systems generally encounter. We are uncertain as to whether the marketplace
will accept our solution to these security problems. We will not be successful if the market does not accept the value proposition that we perceive to be present in our products and services.

Although
Wave has expended considerable resources in developing technology and products that utilize our technology and in business development activities in an attempt to drive the
development of the hardware security market, we do not have a track record as a substantial supplier or service provider to consumers of computer systems. Therefore, uncertainty remains as to whether
we will be accepted as a supplier to the enterprise and consumer markets, which will likely be necessary for us to be a successful commercial enterprise.

16

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Our products have not been accepted as industry standards, which may slow their sales growth.

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

If we do not keep up with technological changes, our product development and business growth will suffer.

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

We are subject to risks relating potential security breaches of our software products.

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

A
party who is able to circumvent our security measures could misappropriate proprietary electronic content or cause interruptions in our operations and those of our strategic partners.
We may be required to expend significant capital and other resources to protect against security breaches or to alleviate problems caused by breaches. Our attempts to implement contracts that limit
our liability to our customers, including liability arising from a failure of security features contained in our products and services, may not be enforceable. We currently do not have product
liability insurance to protect against these risks.

Competition and competing technologies may render some or all of our products non-competitive or obsolete.

An
increasing number of market entrants have introduced or are developing products and services that compete with Wave's. Our competitors may be able to develop products and services
that are more attractive to customers than our products and services. Many of our competitors and potential competitors have substantially greater financial, technical and marketing resources than we
have. Also, many current and potential competitors have greater name recognition and larger customer bases that could be leveraged to enable them to gain market share or product acceptance to our
detriment. Wave's potential competitors include security solutions providers such as RSA Security, Inc. (a division of EMC), Symantec, Computer Associates, Verisign, Inc.,
Entrust, Inc., Ultimaco, Safenet and major systems integrators such as IBM, HP and EDS. In addition, Wave competes with other client security

17

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applications
companies that are developing trusted computing applications, including Softex Incorporated, Phoenix Technologies Ltd., Infineon Technologies AG and Microsoft.

Other
companies have developed or are developing technologies that are, or may become, the basis for competitive products in the field of security and electronic content distribution.
Some of those technologies may have an approach or means of processing that is entirely different from ours. Existing or new competitors may develop products that are superior to ours or that
otherwise achieve greater market acceptance than ours. Due to Wave's early stage, and lower relative name recognition compared to many of our competitors and potential competitors, our competitive
position in the marketplace is vulnerable.

We have a high dependence on relationships with strategic partners that must continue or our ability to successfully produce and market our products will be
impaired.

Due
in large part to Wave's early stage and lower name recognition; we depend upon strategic partners such as large, well established personal computer and semiconductor manufacturers
and computer systems' integrators to adopt our products and services within the Trusted Computing marketplace. These companies may choose not to use our products and could develop or market products
or technologies that compete directly with us. We cannot predict whether these third parties will commit the resources necessary to achieve broad-based commercial acceptance of our technology. Any
delay in the use of our technology by these partners could impede or prohibit the commercial acceptance of our products. Although we have established some binding commitments from some of our
strategic partners, there can be no assurance that we will be able to enter into additional definitive agreements or that the terms of such agreements will be satisfactory. It will be necessary for
Wave to expand upon our current business relationships with our partners, or form new ones, in order to sell more products and services for Wave to become a viable, self-sufficient
enterprise.

Product defects or development delays may limit our ability to sell our products.

We
may experience delays in the development of our new products and services and the added features and functionality to our existing products and services that our customers and
prospective customers are demanding. If we are unable to successfully develop products that contain the features and functionality being demanded by these customers and prospective customers in a
timely manner, we may lose business to our competitors. In addition, despite testing by us and potential customers, it is possible that our products may nevertheless contain defects. Development
delays or defects could have a material adverse effect on our business if such defects and delays result in our inability to meet the market's demand.

If we lose our key personnel, or fail to attract and retain additional personnel, we will be unable to continue to develop our products and
technology.

We
believe that our future success depends upon the continued service of our key technical and management personnel and on our ability to attract and retain highly skilled technical,
management, sales and marketing personnel. Our industry is characterized by a high level of employee mobility and aggressive recruiting of skilled personnel. There can be no assurance that our current
employees will continue to work for us or that we will be able to hire any additional personnel necessary for our growth. Our future success also depends on our continuing ability to identify, hire,
train and retain other highly qualified technical and managerial personnel. Competition for these employees can be intense. We may not be able to attract, assimilate or retain qualified technical and
managerial personnel in the future, and the failure of us to do so would have a material adverse effect on our business.

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We have a limited ability to protect our intellectual property rights and others could infringe on or misappropriate our proprietary
rights.

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

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

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

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

We
believe the export classifications that we have received for our software products allow us to sell our products internationally in an effective, competitively advantageous manner.
Enhancements to existing products may, and new products will be subject to reviews by the BXA to determine what export classification they will receive. Some of our partners demand that our products
be allowed to be exported without restrictions and/or reporting requirements. Current export regulations have, in part, allowed us to receive the desired classification without undue cost or effort.
However, the export regulations may be modified at any time. Currently, we are allowed to export the products for which we've received classification, in an unrestricted manner without a license.
However, modifications to the export regulations could prevent us from exporting our existing and future products in an unrestricted manner without a license. Such modifications could also make it
more difficult to receive the desired classification. If export regulations were to be modified in such a way, we may be put at a competitive disadvantage with respect to selling our products
internationally.

In
addition, import and export regulations of encryption/decryption technology vary from country to country. We may be subject to different statutory or regulatory controls in different
foreign jurisdictions, and as such, our technology may not be permitted in these foreign jurisdictions. Violations of foreign regulations or regulation of international transactions could prevent us
from being able to sell our products in international markets. Our success depends in large part to having access to international markets.

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Our stock price is volatile.

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



In
addition, the stock market in general, and the market prices for technology-related companies in particular, have experienced significant price and volume fluctuations. These broad
market fluctuations may adversely affect the market price of our Class A common stock or any of our other securities for which a market develops, regardless of our operating performance.
Securities class action litigation has often been instituted against companies that have experienced periods of volatility in the market price for their securities. It is possible that we could become
the target of litigation of this kind that would require substantial management attention and expense. The diversion of management's attention and capital resources could have a material adverse
affect on our business. In addition, any negative publicity or perceived negative publicity of any such litigation could have an adverse impact on our business.

We may be subject to conflicts of interest that could adversely slow our corporate governance process.

Our
Board of Directors does not include any representatives of our strategic partners. However, our Board of Directors has included in the past, and may include in the future,
representatives of our strategic partners. It is possible that those corporations may be competing against us, or each other, directly or indirectly. A director who also represents another company may
voluntarily abstain from voting on matters, where there could be conflicts of interest. Even if such a director does abstain, his presence on the Board could affect the process or the results of the
Board's deliberations. We have adopted no policies or procedures to reduce or avoid such conflicts. If such conflicts of interest arise, they may have a materially adverse effect on our business.

Governmental regulation may slow our growth and decrease our profitability.

There
are currently few laws or regulations that apply directly to the Internet. Because our business is dependent in significant respect on the Internet, the adoption of new local,
state, national or international laws or regulations may decrease the growth of Internet usage or the acceptance of Internet commerce, which could, in turn, decrease the demand for our products and
services and increase our costs or otherwise have a material adverse effect on our business.

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

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

If
appropriate opportunities become available, we may attempt to acquire businesses, technologies, services or products that we believe are a strategic fit with our business. If we do
undertake any transaction of this sort, the process of integrating an acquired business, technology, service or product may result in operating difficulties and expenditures and may absorb significant
management attention

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that
would otherwise be available for ongoing development of our business. Moreover, we may never realize the anticipated benefits of any acquisition. Future acquisitions could result in potentially
dilutive issuances of equity securities, the incurrence of debt, contingent liabilities and/or amortization expenses related to certain intangible assets and increased operating expenses, which could
adversely affect our results of operations and financial condition.

If our common stock ceases to be listed for trading on the NASDAQ Global Market, it may harm our stock price and make it more difficult to sell shares.

Our common stock is listed on the NASDAQ Global Market. In order to maintain our NASDAQ listing, NASDAQ Marketplace Rule 4450(b)(4) requires that the bid
price for our common stock not fall below $1.00 per share for a period of 30 consecutive trading days. Because of the volatility in our common stock price, there can be no assurance that we will be
able to maintain compliance with this requirement. If, in the future, our minimum bid price is again below $1.00 for 30 consecutive trading days, under the current NASDAQ Global Market rules we will
have a period of 180 days to attain compliance by meeting the minimum bid price requirement for 10 consecutive days during the
compliance period. If our common stock ceases to be listed for trading on the NASDAQ Global Market, we expect that our common stock would be traded on the NASD's
Over-the-Counter Bulletin Board (OTC-BB) unless NASDAQ grants an additional grace period for transfer to the NASDAQ Capital Market (formerly known as the NASDAQ
SmallCap Market), which also has a similar $1.00 minimum bid requirement. The level of trading activity of our common stock may decline if it is no longer listed on the NASDAQ Global Market or NASDAQ
Capital Market. As such, if our common stock ceases to be listed for trading on the NASDAQ Global Market or NASDAQ Capital Market for any reason, it may harm our stock price, increase the volatility
of our stock price and make it more difficult to sell your shares of our common stock.

Item 1B.    Unresolved Staff Comments

None.

Item 2.    Properties

Summarized below is a listing of properties leased by Wave. Our principal research and development activities are conducted at the Princeton and Cupertino
facilities. Our broadband media distribution services, offered through Wavexpress, are conducted primarily at the New York facility. We believe our office facilities are suitable and adequate for our
business as it is presently conducted.

Facility

Sq. Ft.

Annual Lease Cost

Lease ExpiresLee, MA

13,473

$
148,683

Aug. 2010Princeton, NJ

5,000


168,058

Dec. 2009Cupertino, CA

14,573


499,365

Aug. 2013New York, NY

2,100


120,000

Oct. 2008Orvault, France

1,000


67,260

Sept. 2010


Item 3.    Legal Proceedings

None.

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

None.

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PART II

Item 5.    Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

On July 24, 2006, our Board of Directors approved a reverse stock split of our common stock at a ratio of one-for-three, causing
each three outstanding shares of Class A common stock and Class B common stock to convert automatically into one share of Class A common stock or Class B common stock,
respectively. The par value of Class A common stock and Class B common stock remains $0.01 per share. The reverse split became effective at the close of business on July 25, 2006.
In lieu of fractional shares, stockholders received a cash payment based on an average trading price of the Class A common stock prior to the effectiveness of the reverse split. Except as
otherwise noted, all references to common share and per common share amounts (including warrant shares, shares reserved for issuance and applicable exercise prices) for all periods presented have been
retroactively restated to reflect this reverse split.

Market Information & Dividends

The Class A Common Stock trades on the Nasdaq National Market under the symbol "WAVX". The following table sets forth, for the periods indicated, the high
and low sales prices per share for the Class A Common Stock. There is no established trading market for our Class B Common Stock.

High

LowYear Ended December 31, 2007First Quarter

$
3.49

2.25Second Quarter


2.98

1.80Third Quarter


2.11

1.45Fourth Quarter


1.90

1.21Year Ended December 31, 2006First Quarter

$
2.31

1.50Second Quarter


3.03

1.80Third Quarter


2.50

1.21Fourth Quarter


3.85

1.67


As
of March 5, 2008 there were approximately 23,000 holders of our Class A Common Stock. As of such date, there were 13 holders of our Class B Common Stock.

On
March 5, 2008 the last sale price reported on the Nasdaq National Market for the Class A Common Stock was $1.09.

We
have never declared nor paid any cash dividends on our capital stock. We currently anticipate that we will retain all future earnings, if any, to fund the development and growth of
our business and do not anticipate paying any cash dividends on our capital stock in the foreseeable future.

22

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Performance Graph

The following line graph compares the Company's cumulative total return to stockholders with the cumulative total return of the Nasdaq Market Value Index
and the Computer Related Services SIC Code Index from December 31, 2002 through December 31, 2007. These comparisons assume the investment of $100 on December 31, 2002 and
the reinvestment of dividends. The stock performance on the graph is not necessarily indicative of future stock price performance.

Wave Systems Corp.  Comparison of Cumulative Total Return to StockholdersDecember 31, 2002 through December 31, 2007

GRAPHIC

|         |  | Wave Systems |        | Peer Group
(SIC Code 7379) |   | NASDAQ Market
|-------- |  | ------------ | ------ | -------------------------- | - | -------------
|12/31/02 |  | $            | 100.00 |                            | $ | 100.00       
|12/31/03 |  | $            | 123.31 |                            | $ | 174.24       
|12/31/04 |  | $            | 86.02  |                            | $ | 182.70       
|12/31/05 |  | $            | 51.13  |                            | $ | 198.15       
|12/31/06 |  | $            | 63.41  |                            | $ | 265.02       
|12/31/07 |  | $            | 36.34  |                            | $ | 331.48       

23

---



Securities Authorized for Issuance Under Equity Compensation Plans

The following pertains to Wave's equity compensation plans as of December 31, 2007:

|Plan Category                                                         |                     | Number of
securities to be
issued upon
exercise of
outstanding
options, warrants
and rights
(a) |           | Weighted-average
exercise price
of outstanding
options, warrants
and rights
(b) |      | Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected
in column (a))
(c)
|--------------------------------------------------------------------- | ------------------- | ----------------------------------------------------------------------------------------------- | --------- | ------------------------------------------------------------------------------- | ---- | -----------------------------------------------------------------------------------------------------------------------------------------------
|Equity compensation plans approved by security holders                |                     | 6,947,966                                                                                       |           | $                                                                               | 6.78 |                                                                                                                                                
|Wave equity compensation plans not approved by security holders       |                     | 36,455                                                                                          |           |                                                                                 | 3.16 |                                                                                                                                                
|                                                                      |                     |                                                                                                 |           |                                                                                 |      |                                                                                                                                                
|                                                                      | Total Company plans |                                                                                                 | 6,984,421 |                                                                                 | $    | 6.76                                                                                                                                           
|Wavexpress equity compensation plans not approved by security holders |                     | 624,663                                                                                         |           | $                                                                               | 1.23 |                                                                                                                                                

Wave
equity compensation plans approved by security holders are comprised of 24,018 shares of the N*ABLE Technologies Incorporated 1997 Equity Incentive Plan, 2,685,499 shares of
the 1994 Employee Stock Option Plan, 75,107 shares of the 1996 Performance Stock Option Plan, 708,239 shares of the 1994 Non-Employee Directors Stock Option
Plan and 440,324 shares of the 2004 Employee Stock Purchase Plan.

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

In
connection with an agreement that the Company entered into with nClose, Inc., an outside software development firm, on January 2, 2004 the Company issued a warrant to
purchase 10,000 shares of Class A Common Stock at an exercise price of $3.00 per share, pursuant to an individual compensation plan with nClose. Also, in connection with the same
agreement, on April 30, 2004 an additional warrant was issued to nClose, Inc. to purchase 11,667 shares of Class A Common Stock at an exercise price of $3.00 per
share. The warrants are currently exercisable and expire on January 2, 2009 and April 30, 2009, respectively. No additional warrants are required to be granted pursuant to the
individual compensation plan for nClose.

In
connection with an agreement that Wave entered into with an outside sales representative, in 2003 Wave issued warrants to purchase 14,788 shares of Class A Common Stock at
prices ranging from $2.85 to $4.35 per share, pursuant to an individual compensation plan with the sales representative. No additional warrants are required to be granted pursuant to the
individual compensation plan for the sales representative. These warrants are currently exercisable and expire January 1, 2013 through April 30, 2013.

Wavexpress
issues equity compensation to certain of its employees pursuant to the Wavexpress 1999 Stock Incentive Plan.

24

---



Item 6.    Selected Financial Data

The selected historical consolidated financial data presented below for the years ended December 31, 2007, 2006, 2005, 2004 and 2003 have been derived from
our consolidated financial statements. The following financial data should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the consolidated financial statements and related notes in Part IV, Item 15(a) of this Annual Report on Form 10-K.

Consolidated Statement of Operations Data

|                                                                                             |                                                   | For the year-ended December 31, |            
|-------------------------------------------------------------------------------------------- | ------------------------------------------------- | ------------------------------- | -----------
|
|Net Revenues                                                                                 |                                                   | $                               | 6,306,960  
|                                                                                             | Cost of Sales                                     |                                 |            
|                                                                                             |                                                   |                                 |            
|                                                                                             | Gross Profit                                      |                                 |            
|                                                                                             |                                                   |                                 |            
|Operating expenses:                                                                          |                                                   |                                 |            
|                                                                                             | Selling, general and administrative               |                                 |            
|                                                                                             | Research and development                          |                                 |            
|                                                                                             | Inventory provision                               |                                 |            
|                                                                                             | Write-off of intangible and other impaired assets |                                 |            
|                                                                                             |                                                   |                                 |            
|                                                                                             |                                                   |                                 | 25,780,833 
|                                                                                             |                                                   |                                 |            
|Other income (expense):                                                                      |                                                   |                                 |            
|                                                                                             | Liquidated damages                                |                                 |            
|                                                                                             | Gain on decrease in value of warrant liability    |                                 |            
|                                                                                             | Recovery of officer note receivable               |                                 |            
|                                                                                             | Gain on sale of marketable securities             |                                 |            
|                                                                                             | Net interest and other income (expense)           |                                 |            
|                                                                                             |                                                   |                                 |            
|Total Other Income / (expense)                                                               |                                                   |                                 | 334,292    
|                                                                                             |                                                   |                                 |            
|Net loss                                                                                     |                                                   |                                 | (19,951,551
|Accrued dividends on preferred stock (including $5,485,000 of accretion of discount in 2003) |                                                   |                                 |           
|                                                                                             |                                                   |                                 |            
|Net loss to common stockholders                                                              |                                                   | $                               | (19,951,551
|                                                                                             |                                                   |                                 |            
|Weighted average number of common shares outstanding during the period                       |                                                   |                                 | 46,660,794 
|Loss per common share-basic and diluted                                                      |                                                   | $                               | (0.43      
|                                                                                             |                                                   |                                 |            
|Cash dividends declared per common share                                                     |                                                   |                                 | -0-        

Consolidated Balance Sheet Data

|                                        |  | As of December 31,
|--------------------------------------- |  | ------------------
|
|Working capital                         |  | $                 
|Total assets                            |  |                   
|Long-term liabilities                   |  |                   
|Total liabilities                       |  |                   
|Total stockholders' equity (deficiency) |  | $                 

25

---





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

Overview

In 2006 and 2007, Wave's management focused its activities and resources on the continued development and marketing of the TCG-compliant software
products known as the EMBASSY Trust Suite and EMBASSY Trust Server Applications. As the market for TPM-enabled products has developed, with computing devices being shipped in volume by
leaders in the PC industry, Wave has developed its products to support security hardware, based on the TCG specifications. Wave's products are unique because they support cross platform
interoperability for the currently available TPM chips from Winbond Electronics Corp. ("WEC"), Broadcom, Atmel, Infineon and ST Microsystems, and have been certified and/or approved for usage on
TPM-based platforms shipped by Dell, Intel, Gateway (acquired by MPC), IBM and HP.

Wave
is devoting its resources to capitalize on the opportunities, and overcome the specific challenges, presented by this developing market as it continues to pursue a strategy of
educating the marketplace on the benefits that trusted computing has to offer, while continuing to develop the basic software applications designed to enable this emerging technology. The market
trends and opportunities that management focused the company's activities during the year ended December 31, 2007 included the following:



26

---





In
pursuing these opportunities, we recognize many significant challenges that must be overcome, including:



As
more PC and chip OEMs have begun introducing their Trusted Platform offerings, management has focused on entering into licensing contracts pursuant to which the OEM licenses
our applications and
distributes them as part of their offering, paying Wave a royalty for each unit shipped. Wave currently has signed such bundling agreements with seven separate OEM partners. Revenue recognized on
these contracts for the years ended December 31, 2007 and 2006 was approximately $5,971,000 and $2,598,000, respectively.

Management
is also focused on developing the client and server-side applications and tools that will enable enterprises to manage an IT infrastructure that relies on products
built using TCG specifications. Wave is devoting a significant portion of its research and development budget to address this opportunity, as this will be a key ingredient for enterprises in
successfully implementing a Trusted Platform solution.

Management
is focusing on opportunities for its eTMS product suite to provide digital signing and document management solutions to the financial services and other vertical markets in
which there is a clear and identifiable value proposition in implementing these solutions. Although we have met significant implementation challenges and long sales cycles with this effort, we have
entered into contracts with Efficient Forms, LLC and Realtime Solutions Group, LLC in the financial services sector in 2006 and 2007. We continue to pursue additional opportunities for
the eTMS product line.

Wavexpress
is focused on building a sustainable revenue stream by establishing partnerships with branded content providers to provide primarily advertising supported video entertainment
services. Wavexpress' TVTonic service offers hundreds of video feeds, a significant number of which are signed to revenue sharing agreements for ad placements. The service is designed to support any
video channel distributed via RSS. RSS is the standard format for blogs and podcasts and is being increasingly used for open video distribution on the Internet. TVTonic is promoted by Microsoft with
all installations of their Media Center software. Media Center is standard with Microsoft Vista Premium and Vista Ultimate, as well as XP Media Center Edition. In addition, Wavexpress is extending its
technology so that its subscriber management system can leverage the added security of a TPM and is preparing back-office systems for standalone deployment into enterprise installations.
Management plans to devote ongoing development resources toward enhancing the TVTonic client software and services.

27

---



Operating Expense Trends

Selling, general and administrative expenses ("SG&A") increased from 2006 to 2007 as a result of expending considerable resources in the sales, marketing and
business development and support activities during 2007, net of allocated non-cash, share-based compensation expenses incurred during 2007 and 2006 in accordance with SFAS 123(R).
For the years ended December 31,
2007, 2006 and 2005, we have incurred approximately $15.2 million, $12.6 million and $11.6 million, in SG&A expenses, respectively. Non-cash, share-based compensation
expenses allocated to SG&A for the years ended December 31, 2007 and 2006 were approximately $1.2 million and $1.1 million, respectively. This expense was not incurred during the
year ended December 31, 2005 since Wave did not adopt SFAS 123(R) until its effective date of January 1, 2006.

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

Given
the early stage nature of the markets for products that use our technology, we have expended and will continue to expend considerable resources in the sales, marketing, business
development and support activities referred to above that will be necessary for us to be successful in developing salable products and markets for our technology. The outlook over the
short-term is for sales and marketing expenditures to remain relatively flat, compared with 2007, with research and development expected to increase compared to 2007. (See Liquidity and Capital Resources)

The
following discussion related to the consolidated financial statements of Wave should be read in conjunction with the financial statements appearing in Item 8.

Critical Accounting Policies

Wave's discussion and analysis of its financial condition and results of operations are based on the Company's consolidated financial statements, which have been
prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the
reporting periods. On an ongoing basis, management evaluates its estimates and judgments, including those related to revenue recognition, accounts receivable reserves, valuation of
long-lived and intangible assets, accounting for joint ventures, software development and share based compensation. Management bases its estimates on historical experience and on various
other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The
following accounting policies are deemed critical to the understanding of the consolidated financial statements included under Item 8Financial Statements and
Supplementary Data.

Revenue RecognitionWave's business model targets revenues from various sources including: licensing of EMBASSY Trust Suite,
Wavexpress' broadband media distribution and eTMS software products and development contracts. Some of our sales arrangements include multiple-elements, and/or require significant modification or
customization of our software.

Wave
follows the provisions of statement of position SOP 97-2,Software Revenue Recognitionas amended by
SOP 98-9, Modification of SOP 97-2,Software Revenue Recognition, with Respect to Certain Transactions. Generally,
Wave recognizes revenue when it is realized or realizable and earned. Wave considers revenue realized or realizable and earned when persuasive evidence of an arrangement exists,

28

---



delivery
has occurred, the sales price is fixed or determinable and collectability is reasonably assured. Wave reduces revenue for estimated customer returns, rotations and sales rebates when such
amounts can be estimated. When these amounts cannot be estimated Wave defers revenue until the product is sold to the end-user. Revenue from software license agreements that have
significant customizations and modification of the software product is deferred and recognized in a manner that approximates the percentage of completion method. In addition to the aforementioned
general policy, the following are the specific revenue recognition policies for each major category of revenue.



Revenue from delivered elements of one-time charge licensed software is recognized at the inception of the license term, provided Wave has
vendor-specific objective evidence of the fair value of each undelivered element, for arrangements that contain multiple elements. Revenue is deferred for undelivered elements for these arrangements.
Revenue is also deferred for the entire arrangement, if vendor-specific objective evidence does not exist for each undelivered contract element. Examples of undelivered elements in which the timing of
delivery is uncertain include contractual elements that give customers rights to any future upgrades at no additional charge or future maintenance that is provided within the overall price. The
revenue that is deferred for any contract element is recognized when all of the revenue recognition criteria have been met for that element.

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



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

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

SFAS
No. 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the
award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company's consolidated statement of operations. SFAS No. 123(R) supersedes Wave's
previous accounting under the provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." As permitted by SFAS No. 123, Wave measured compensation cost for options granted
prior to January 1, 2006, in accordance with Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees" and related interpretations. Accordingly, no
accounting recognition was given to stock options granted at fair market value until they were exercised. Upon exercise, net proceeds, including tax benefits realized, were credited to equity.

Wave
adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006. In
accordance with the modified

29

---



prospective
transition method, Wave's consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R).

Results of Operations

Comparison of the years ended December 31, 2007 and 2006

Wave had revenues of $6,306,960 and $3,116,381 for the years ended December 31, 2007, and 2006, respectively. Licensing revenues increased by $3,551,326,
due to higher volume of shipments of Wave's OEM customer products, primarily as a result of its OEM relationship with Dell, for which Wave receives royalty income. Services revenue decreased by
$360,747 due to a decrease in non-recurring government time-and-materials contracts.

The
table below sets forth the components that make up the revenue for the year ended December 31, 2007, and 2006:

2007

2006

Increase/
(Decrease)

ChangeLicensing

$
6,223,487

$
2,672,161

$
3,551,326

132
%Services


83,473


444,220


(360,747
)
(81
)%Total Net Revenues

$
6,306,960

$
3,116,381

$
3,190,579

102
%


Cost
of sales for the year ended December 31, 2007, was $811,970, compared with $983,671 for the same period in 2006. The change in cost of sales was due to a decrease in
amortization expense as
most capitalized software became fully amortized, offset by higher customer support costs in connection with the increased license revenue during the year ended December 31, 2007 versus the
prior year.

For
the reasons noted above, gross profit for the year ended December 31, 2007 and 2006 was $5,494,990 and $2,132,710, respectively. Wave's gross profit percentage was 87.1% for
the year ended December 31, 2007 as compared to 68.4% for the year ended December 31, 2006.

SG&A
expenses for the year ended December 31, 2007, were $15,222,896, as compared to $12,598,389 for the comparable period of 2006, an increase of approximately 21%. The increase
was due mainly to an increase in salaries and related benefits totaling approximately $1,169,000, associated with salary rate increases and headcount additions to accommodate additional sales,
marketing, business development and support activities, which exceeded those during the year ended December 31, 2006. Non-cash, share-based compensation expense was approximately
$1,125,000 at Wave and $105,000 at Wavexpress, in accordance with SFAS 123(R). This expense totaled approximately $953,000 for Wave and $103,000 for Wavexpress for the year ended
December 31, 2006. In addition, to accommodate additional sales, marketing, business development and support activities, professional feesprimarily consulting
feesincreased approximately $527,000 and additional travel expenses of approximately $306,000 were incurred during the year ended December 31, 2007 versus the comparable period of
2006. Included in the SG&A expenses listed above are Wavexpress' selling, general and administrative expenses, which were $1,492,373 and $1,059,405 for the years ended December 31, 2007, and
2006, respectively. This 41% increase was due to primarily to an increase in professional fee expenditures of approximately $333,000.

The
activities supported by SG&A expenses include business development, sales, marketing (including product development and product management), corporate communications and public
relations, information technology and management information systems, human resources, accounting, executive management, corporate governance and general administrative functions. Given the early
stage nature of the markets for products that use our technology, we have expended and will continue to expend considerable resources, in the sales, marketing, business development and support
activities referred to above that will be necessary for us to be successful in developing products and markets for our technology. We expect SG&A expenses to continue to increase in the near future to
accommodate our expected sales growth and support our sales, marketing, business development and support activities. Actual expenditures may vary depending upon the future business needs of Wave.

30

---



Research and development expenses for the year ended December 31, 2007, were $10,557,937, as compared to $8,486,368 for the comparable period of 2006, an increase of 24%. This
increase was primarily attributable to increased salaries, fringe and benefit expenditures of approximately $1,538,000 associated with salary rate increases and headcount additions to accommodate
additional research and development efforts that were undertaken since December 31, 2006. In addition, non-cash, share-based compensation expense was approximately $634,000 at Wave
and $85,000 at Wavexpress, in accordance with SFAS 123(R). This expense totaled approximately $408,000 for Wave and $66,000 for Wavexpress for the year ended December 31, 2006.
Wavexpress' research and development expenditures included in the above were $1,416,832 and $1,343,748 for the years ended December 31, 2007, and 2006, respectively, for an increase of 5%. The
increase in Wavexpress R&D expense was due primarily to the increase in salaries and related benefits noted above and an increase in rent expenditures offset by a decrease in product development
costs.

Interest
income for the year ended December 31, 2007, was $334,292 as compared to $163,980 for the comparable period of 2006. The increase in interest income is primarily
attributable to higher average balances of Wave's money market accounts and higher rates of return for the year ended December 31, 2007, compared with the same period in 2006.

Due
to the reasons set forth above, our net loss for the year ended December 31, 2007 was $19,951,551 as compared to $18,785,273 for year ended December 31, 2006.

Comparison of the years ended December 31, 2006 and 2005

Wave had revenues of $3,116,381 and $1,018,464 for the year ended December 31, 2006, and 2005, respectively. Licensing revenues increased by $1,698,103,
due to higher volume of shipments of Wave's OEM customer products for which Wave receives royalty income. Services revenue increased by $399,814 due to revenue from government
time-and-materials contracts that were signed during the first quarter of 2006, and completed in the 2nd quarter of 2006.

The
table below sets forth the components that make up the revenue for the year ended December 31, 2006, and 2005:

2006

2005

Increase/
(Decrease)

ChangeLicensing

$
2,672,161

$
974,058

$
1,698,103

174
%Services


444,220


44,406


399,814

900
%Total Net Revenues

$
3,116,381

$
1,018,464

$
2,097,917

206
%


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

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

31

---



listed
above are Wavexpress' selling, general and administrative expenses, which were $1,059,405 and $1,096,335 for the years ended December 31, 2006, and 2005, respectively. This 3% decrease
was due to the reasons set forth above.

Research
and development expenses for the year ended December 31, 2006, were $8,486,368, as compared to $6,937,618 for the comparable period of 2005, an increase of 22%. This
increase was primarily attributable to increased salaries, fringe and benefit expenditures of approximately $1,053,000 associated with salary rate increases and headcount additions to accommodate
additional research and development efforts that were undertaken since December 31, 2005. In addition, non-cash, share-based compensation expense was approximately $408,000 at Wave
and $66,000 at Wavexpress in connection with the adoption of SFAS 123(R) on January 1, 2006. Wavexpress' research and development expenditures included in the above were approximately
$1,343,748 and $1,127,004 for the years ended December 31, 2006, and 2005, respectively, for an increase of 19%. The increase in Wavexpress R&D expense was due to the share-based compensation
referred to above and additional consultant & product development expenses of approximately $102,000 associated with an increase in research and development efforts during 2006.

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

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

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

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

Liquidity and Capital Resources

Wave has incurred substantial operating losses since its inception, and as of December 31, 2007, has an accumulated deficit of $323,483,650. We also expect
Wave will incur an operating loss for the calendar year of 2008. As of December 31, 2007, we had working capital of $1,676,412.

Sources and Uses of Cash

At December 31, 2007, we had $3,714,030 in cash and cash equivalents versus $7,965,994 as of December 31, 2006, resulting in a net decrease in cash
of $4,251,964 for the year ended December 31, 2007. The table below shows the year-to-year comparison of the significant elements of cash used in or provided by
operating, investing and financing activities and a reconciliation of each year's operating results reported in the statement of operations to the total decrease in cash in the two years ended
December 31, 2007 and 2005 and to the total increase in cash in the year ended December 31, 2006.

32

---



As
shown below, the total net change in cash over the last three years has fluctuated significantly from a net cash decrease for the year ended December 31, 2005 of $3,799,890 to
a net cash increase for the year ended December 31, 2006 of $5,959,972 to a net cash decrease for the year ended December 31, 2007 of $4,251,964.

Consolidated Statement of Cash Flow Data

|                                                                                 |  | For the years ended December 31, |            
|-------------------------------------------------------------------------------- |  | -------------------------------- | -----------
|
|Cash flows from operating activities:                                            |  |                                  |            
|Net loss                                                                         |  | $                                | (19,951,551
|                                                                                 |  |                                  |            
|Realized gain from the sale of marketable securities                             |  |                                  |           
|Share-based compensation expense                                                 |  |                                  | 1,969,271  
|Gain on decrease in value of warrant liability                                   |  |                                  |           
|Depreciation and amortization                                                    |  |                                  | 355,884    
|Compensation paid in the form of stock options & warrants                        |  |                                  |           
|                                                                                 |  |                                  |            
|Total adjustments to reconcile net loss to cash provided by operating activities |  |                                  | 2,325,155  
|                                                                                 |  |                                  |            
|Proceeds from liquidation of other assets                                        |  |                                  |           
|Increase in prepaid expenses, receivables and other assets                       |  |                                  | (667,355   
|(Reduction) increase in deferred revenue                                         |  |                                  | (115,034   
|Increase (reduction) in accounts payable and accrued expenses                    |  |                                  | 217,971    
|                                                                                 |  |                                  |            
|Changes in assets & liabilities                                                  |  |                                  | (564,418   
|                                                                                 |  |                                  |            
|Net cash used in operating activities                                            |  |                                  | (18,190,814
|                                                                                 |  |                                  |            
|Cash flows from investing activities:                                            |  |                                  |            
|Disbursements for capital expenditures                                           |  |                                  | (618,672   
|Proceeds provided by sales of marketable equity securities                       |  |                                  |           
|                                                                                 |  |                                  |            
|Net cash (used in) provided by investing activities                              |  |                                  | (618,672   
|                                                                                 |  |                                  |            
|Cash flows from financing activities:                                            |  |                                  |            
|Proceeds from sale of common stock                                               |  |                                  | 14,229,331 
|Proceeds from exercise of employee stock options                                 |  |                                  | 328,432    
|Cash paid in lieu of fractional shares                                           |  |                                  | (241       
|Proceeds from the exercise of warrants                                           |  |                                  |           
|                                                                                 |  |                                  |            
|Net cash provided by financing activities                                        |  |                                  | 14,557,522 
|                                                                                 |  |                                  |            
|Net (decrease) increase in cash                                                  |  | $                                | (4,251,964 
|                                                                                 |  |                                  |            

Cash used in operations

The amount of cash used in operations increased to $18,190,814 for the year ended December 31, 2007 from $17,026,733 used for the year ended
December 31, 2006, which decreased from $17,121,071 used for the year ended December 31, 2005. As shown above, the fluctuations in cash used in operations were the result of the changes
in the net losses in each of the three years ended December 31, 2007, as discussed in detail in the previousResults of Operationssection,
adjusted for non-cash items of the net losses such as realized gains on sales of marketable securities, non-cash

33

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share-based
compensation and changes to assets and liabilities for net cash outlays and/or receipts which under generally accepted accounting principles, are not reported in the Statement of
Operations.



These amounts represent items reported in Wave's Consolidated Statement of Operations, that do not represent an outlay or receipt of cash in the year that they
are reported, under generally accepted accounting principles. These items in the aggregate make up a significant portion of the differences between Wave's reported net loss year over year, versus the
differences in the amount of cash used by Wave's operations over each of the periods. These items resulted in a net add-back to net loss of $2,325,155 for the year ended
December 31, 2007 versus $2,216,281 for the year ended December 31, 2006 and $277,718 for the year ended December 31, 2005. The individual items that make up these adjustments are
listed in the table above and described in greater detail in theResults of OperationsandOther Income and
Expensesections above. In addition, changes in asset and liability accounts, as shown above, represent additional sources or uses of cash in each of the three years.
Accordingly, the overall net loss increased by $1,166,278 (to $19,951,551 from $18,785,273) for the year ended December 31, 2007 versus the year ended December 31, 2006, and cash used in
operating activities increased by $1,164,081 (to $18,190,814 from $17,026,733). In comparing the year ended December 31, 2006 to 2005, the overall net loss increased by $1,222,811 (to
$18,785,273 from $17,562,462) for the year ended December 31, 2006 versus the year ended December 31, 2005, while cash used in operating activities decreased by $94,338 (to $17,026,733
from $17,121,071). This was due in large part to the share-based compensation expense included in the 2006 loss, of $1,556,042 which is
not a use of cash, and is therefore added back to the net loss to arrive at cash used in operating activities.

Cash Flows from investing activities

As displayed in the table above, cash used in investing activities consisted of funds used to acquire capital assets totaling $618,672, $328,604 and $160,829 for
the years ended December 31, 2007, 2006 and 2005, respectively. Wave expects to continue to acquire fixed assets primarily to replace computer equipment to be used internally. These
expenditures are expected to continue at approximately the same level as the 2007 expenditures.

During
the year ended December 31, 2005, Wave sold 259,670 shares of Saflink, in a series of separate sales, for total proceeds of $336,309.

Net
cash generated from investing activities decreased by $290,068, as a result of higher capital expenditures, for the year ended December 31, 2007 versus the year ended
December 31, 2006 and decreased by $504,084 for the year ended December 31, 2006 versus the year ended December 31, 2005. The cash generated from the sale of marketable securities
was a source of cash for Wave in 2005 versus the year ended December 31, 2006. This, combined with lower capital expenditures in the year ended December 31, 2005, accounted for the
decrease in net cash generated from investing activities for the year ended December 31, 2006 versus the year ended December 31, 2005.

Cash Flows from financing activities

Because Wave did not have sufficient cash on hand, nor did it generate sufficient revenues to fund the amount of cash used for operations and acquisition of
capital assets for the years ended December 31, 2007, 2006 and 2005, we needed to finance much of our operations through the sale of newly issued common stock as described below.

34

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On May 24, 2007, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 7,317,073 shares of Class A Common
Stock, par value $0.01 per share, to certain purchasers for an aggregate purchase price of $15,000,000. These shares were priced at $2.05 per share. Securities Research Associates, Inc. ("SRA")
entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of
this offering. Wave also agreed to issue a warrant to SRA to purchase up to 365,853 shares of Class A common stock at an exercise price of $2.58 per share. The warrant expires on May 24,
2009. Wave realized net proceeds of $14,229,331 after deducting the placement agent fees of $750,000 and additional legal and other fees associated with the issuance of these securities which totaled
$20,669. The shares sold on May 24, 2007 were offered and issued pursuant to a shelf registration statement which was filed by Wave on March 20, 2007 and declared effective by the
Commission on April 27, 2007.

On
October 30, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 3,517,230 shares of Class A Common Stock, par value $0.01
per share, to certain purchasers for an aggregate purchase price of $9,602,038. These shares were priced at $2.73 per share. Securities Research Associates, Inc. ("SRA") entered into a
placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering.
Wave also agreed to issue a warrant to SRA to purchase up to 175,861 shares of Class A common stock at an exercise price of $2.73 per share. The warrant expired unexercised on
November 30, 2007. Wave realized net proceeds of $9,101,224 after deducting the placement agent fees of $484,000 and additional legal and other fees associated with the issuance of these
securities which totaled $16,814. The shares sold on October 30, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and
declared effective by the Commission on January 13, 2006.

On
August 4, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 2,336,752 shares of Class A Common Stock, par value $.01 per
share, to certain purchasers for an aggregate purchase price of $4,790,342. These shares were priced at $2.05 per share. Securities Research Associates, Inc. ("SRA") entered into a placement
agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering. Wave also
agreed to issue a warrant to SRA to purchase up to 116,837 shares of Class A common stock at an exercise price of $2.05 per share. The warrant expired unexercised on September 3, 2007.
Wave realized net proceeds of $4,528,376 after deducting the placement agent fees of $239,517 and additional legal and other fees associated with the issuance of
these securities which totaled $22,449. The shares sold on August 4, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005
and declared effective by the Commission on January 13, 2006.

On
May 3, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 2,012,500 shares of Class A Common Stock to certain purchasers
for an aggregate purchase price of $4,830,000. The shares were priced at $2.40 per share. SRA entered into a placement agency agreement with Wave in which they agreed to act as placement agent in
connection with the offering. Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering. Wave also agreed to issue a warrant to SRA to purchase up to 100,625 shares of
Class A common stock at an exercise price of $2.40. The warrant expired unexercised on June 3, 2007. Wave realized net proceeds of $4,548,439 after deducting the placement agent fees of
$241,500 and additional legal and other fees associated with the issuance of these securities of $40,061. The shares sold on May 3, 2006 were offered and issued pursuant to a shelf registration
statement which was filed by Wave on December 16, 2005 and declared effective by the Commission on January 13, 2006.

35

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On
February 15, 2006, Wave entered into a securities purchase agreement, pursuant to which Wave agreed to sell and issue 2,782,866 shares of Class A Common Stock for $1.605
per share, to certain purchasers for an aggregate purchase price of $4,466,500. The purchasers were also granted warrants (the "Warrants") to purchase up to 516,956 shares of Class A common
stock at an exercise price of $2.16. The Warrants were exercisable for a period of six months following the date of issuance. All unexercised warrants granted in connection with the
February 15, 2006 securities purchase agreement expired on August 16, 2006. The placement agent, JPC Capital Partners, Inc. (formerly Corpfin, Inc.) (the "Placement
Agent"), had entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay the Placement Agent a fee equal to
4.0% of the gross proceeds of this offering. Wave realized net proceeds of $4,250,212 after deducting the placement agent fees of $216,289 and additional legal and other fees associated with the
issuance of these securities. The shares sold on February 15, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and
declared effective by the Commission on January 13, 2006.

On
December 5, 2005, Wave sold and issued 1,994,302 shares of Class A Common Stock for $1.755 per share, for gross proceeds of $3,500,000, for which it received net
proceeds of $3,340,890 after paying underwriter and other fees, which totaled $159,110. The purchasers were also issued warrants to purchase 364,583 shares of Common Shares within six months at an
exercise price of $2.40 per share. All of these warrants expired unexercised on May 5, 2006.

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

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



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

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



During 2007, an employee exercised stock options resulting in the issuance of 3,315 shares of Wave Class A Common Stock for proceeds of $8,055, at a price
of $2.43 per share.

On
December 1, 2007 Wave issued 127,420 shares of Class A Common Stock to Wave and Wavexpress employees for $1.20 per share, pursuant to the Wave 2004 Employee Stock
Purchase Plan. Wave received proceeds of $152,712, from the sale of these shares.

36

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On
June 1, 2007 Wave issued 91,746 shares of Class A Common Stock to Wave and Wavexpress employees for $1.83 per share, pursuant to the Wave 2004 Employee Stock Purchase
Plan. Wave received proceeds of $167,665, from the sale of these shares.

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

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

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

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

Summary analysis of historical cash flows and future outlook

It is evident from the table above that Wave's use of cash to fund operations has fluctuated significantly over the three-year period presented. The
detailed discussion of this trend is presented in the analysis of the results of operations above. In addition, Wave needed to raise a significant amount of additional funds primarily from issuing new
shares of common stock as detailed in the above discussion of cash flows from financing activities.



Wave estimates that its total expenditures to fund operations for the year ending December 31, 2008 will be approximately $26,600,000, including research
and development, acquisition of capital assets, sales and marketing, general corporate expenses and overhead.

Expected
sources of capital include the following:



Given
Wave's capital requirements for the year ending December 31, 2008 as indicated above, and our cash balance as of December 31, 2007, Wave will be required to raise
additional capital to continue to fund its operations. On February 29, 2008, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 3,173,500 shares of
Class A Common Stock, par value $0.01 per share, to certain purchasers for an aggregate purchase price of $3,490,850. These shares were priced at $1.10 per share. Wave also agreed to issue
warrants to the subscribers to purchase up to 952,050 shares of Class A common stock at an exercise price of $1.15 per share. The warrants expire on February 28, 2013. Securities
Research Associates, Inc. ("SRA") entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a
fee equal to 6.0% of the gross proceeds of this offering. Wave also agreed to issue a warrant to SRA to purchase up to 190,410 shares of Class A common stock at an exercise price of $1.33 per
share. The warrant expires on February 28, 2010. Wave realized net proceeds of approximately $3,221,000 after deducting the placement agent fees of $209,451 and additional legal and other fees
associated with the issuance of these securities which totaled approximately $60,000. The shares sold on February 29, 2008 were offered and issued pursuant to a shelf registration statement

37

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which
was filed by Wave on March 20, 2007 and declared effective by the Commission on April 27, 2007.

We
may obtain additional funding as needed, from further sales of newly issued shares of Class A Common Stock, including the sale of Class A Common Stock under the
remaining availability of our $25,000,000 shelf registration statement that we filed on March 20, 2007 that the Securities and Exchange Commission declared effective on April 27, 2007.
Approximately $4,411,000 in gross proceeds is available under the March 20, 2007 shelf registration statement, which may be utilized for future financings. We can provide no assurances as to
whether we will be successful in raising the needed capital to continue as a going concern.



Wave receives revenue from licensing its EMBASSY Trust Suite software through distribution arrangements with OEM partners as described below. In addition, Wave
received revenues from software development and other services. Total cash received from all revenue sources in 2007 was approximately $5,666,000 versus approximately $2,633,000 for 2006.

In
March 2007, Wave signed a distribution agreement with Seagate Technology LLC ("Seagate") that permits Seagate to distribute Wave's management software on Seagate's Momentus
5400 Full Disc Encryption hard drive ("FDE.2"). Wave is being paid a per unit royalty fee for each Seagate shipment which includes Wave's software. Shipments began in late July 2007. We are working
with Seagate to market our products in an effort to drive volume of shipments of their TPM-equipped FDE.2 hard drives. However, we have no reliable basis to predict how many of Seagate's
TPM-equipped FDE.2 hard drives will be purchased or what the resultant revenue to Wave might be from this program. There are no minimum royalty or shipped quantity requirements.

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

Wave's
license and distribution agreements began to generate royalty revenue in the second quarter of 2006. The aggregate amount of royalty revenue from these arrangements was a
significant contributor to Wave's revenue growth over 2006 and 2007. Revenue from these contracts in future years may also be material. We expect to continue to generate cash flow from these
agreements as long as the agreements remain in effect and our software continues to ship with these products. We continued to experience modest upgrade activity during the fourth quarter of 2007 as
enterprise customers began to purchase the packages offered in connection with these distribution agreements. We recorded modest initial revenues from the sale of license upgrade packages during 2006.



Because Wave does not have sufficient cash to fund operations for the year ending December 31, 2008, and there is uncertainty as to whether Wave will
generate sufficient revenues to fund its operations over this time period, Wave has been, and will continue to be, actively engaged in financing activities in order to generate additional funding to
cover its operating costs for the year ending December 31, 2008. These activities have included the sale of 3,173,500 shares of common stock at

38

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$1.10
per share (and warrants to purchase 952,050 shares of common stock at an exercise price of $1.15 per share) for gross proceeds of $3,490,850 on February 29, 2008.

We
will be required to sell additional shares of common stock, preferred stock, obtain debt financing or engage in a combination of these financing alternatives, to raise additional
capital to continue to fund our operations for the year ending December 31, 2008. The availability and amount of any such financings are unknown at this time. Wave may also be required to
reduce expenses which may significantly impede its ability to meet its sales, marketing and development objectives. Given the available cash currently on hand, including the net proceeds from the
February 29, 2008 financing described above, and our expenditure forecast for the year ending December 31, 2008, we estimate that we will need at least $12,700,000 in additional cash, in
order to continue as a going concern for the next twelve months ending December 31, 2008.



Because the information security services market and the TCG hardware security category in particular are in early stages of development, customer requirements
may change or new competitive pressures can emerge which could require a shift in product development and/or market strategy. Should such shifts occur, they may require development, marketing and
sales strategies to re-start or expand, which would likely increase operating costs, requiring additional capital. Such shifts have occurred several times throughout Wave's history,
requiring significant changes in strategy and business plan.

Furthermore,
the achievement of sufficient revenue is dependent upon continued significant expenditures, which will likely be required for research and development and sales and
marketing to increase market awareness for our products. Therefore, if Wave is not able to begin to generate significant revenues by December 31, 2008 to cover its operating costs, it will need
to generate capital from other sources, including raising funds through the issuance of additional common stock, preferred stock and/or debt to fund its operations beyond December 31, 2008.



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

|                             |  | Within one
year |         | Years two
and three |   | Years four
and five |  | Thereafter |           | Total
|---------------------------- |  | --------------- | ------- | ------------------- | - | ------------------- |  | ---------- | --------- | -----
|Operating leases commitments |  | $               | 983,366 |                     | $ | 1,516,541           |  | $          | 1,056,733 |      



As of December 31, 2007, Wave had available net operating and capital loss carryforwards for Federal income tax purposes of approximately
$285.0 million, which expire beginning in 2008 through 2027. Because of the "change in ownership" provisions of the Tax Reform Act of 1986, our net operating and capital 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 Wave occurs
within any three-year period. We have made no determination concerning whether there have been such cumulative changes in ownership or the impact on the utilization of the loss
carryforwards if such changes have occurred. However, in considering Section 382 of the Internal Revenue Code, we believe that it is likely that such a change in ownership occurred prior to or
following the completion of our initial public offering in September 1994 and,
potentially, in periods following. As a result, all of the utilization of our net operating losses is likely to be subject to annual limitations.

39

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Wave's consolidated financial statements as of December 31, 2007 have been prepared under the assumption that we will continue as a going concern. Wave's
independent registered public accounting firm, KPMG LLP, has issued a report dated March 17, 2008, that includes an explanatory paragraph referring to our significant operating losses
and substantial doubt of our ability to continue as a going concern. (See Note 2 to Wave's consolidated financial statements.)

Recent Accounting Pronouncements

Effective January 1, 2007, Wave adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxesand interpretation of
FASB Statement 109" ("FIN 48"), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken, or expected
to be taken, in a tax return, and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transition. The adoption of FIN 48
did not result in a cumulative adjustment to Wave's accumulated earnings.

In
February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an amendment of
FASB Statement No. 115(SFAS No. 159). SFAS No. 159 permits entities to elect to measure financial assets and financial liabilities, and certain other
items at fair value. SFAS No. 159 is effective as of the beginning of the first fiscal year that begins after November 15, 2007, and therefore its provisions will be applied for the
Company on January 1, 2008. Wave does not expect the implementation of SFAS No. 159 to have a material impact on the Company's consolidated financial statements.

In
September 2006, the FASB issued SFAS No. 157,Fair Value Measurements (SFAS No. 157). This Statement defines fair value,
establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and therefore its provisions will be adopted by Wave on January 1, 2008. Wave does not expect the
implementation of SFAS No. 157 to have a material impact on the Company's consolidated financial statements.

In
November 2007, the EITF reached a consensus on EITF Issue No. 07-1,Accounting for Collaborative Arrangements(EITF 07-1). EITF 07-1 provides guidance on the identification of collaborative arrangements and establishes reporting requirements for transactions between
participants in a collaborative arrangement and between participants in the arrangement and third parties. EITF 07-1 is effective for fiscal years beginning after
December 15, 2008, and interim periods within those financial years, and therefore would be effective for Wave beginning January 1, 2009. Wave is evaluating the impact
EITF 07-1 will have on its consolidated financial statements.

In
December 2007, the FASB issued Financial Accounting Standards Board Statement (FAS) No. 141 (R)," Business Combinations," (FAS 141R), which requires most
identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at "full fair value." Under FAS 141R, all business
combinations will be accounted for under the acquisition method. Significant changes, among others, from current guidance resulting from FAS 141R includes the requirement that contingent assets
and liabilities and contingent consideration shall be recorded at estimated fair value as of the acquisition date, with any subsequent changes in fair value charged or credited to earnings. Further,
acquisition-related costs will be expensed rather than treated as part of the acquisition. FAS 141R is effective for periods beginning on or after December 15, 2008. We expect the
adoption of FAS 141R will increase costs charged to operations.

40

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In
December 2007, the FASB issued SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB
No. 51(SFAS No. 160). SFAS 160 amends ARB No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary
and for the deconsolidation of a subsidiary, in which the noncontrolling interest will be reclassified as equity; and the income, expense and comprehensive income from a noncontrolling interest will
be fully consolidated. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008, and therefore would be effective
for Wave beginning January 1, 2009. Wave is evaluating the impact SFAS 160 will have on its consolidated financial statements.

Item 7A.    Quantitative and Qualitative Disclosures about Market Risk

The exposure to market risk associated with interest rate-sensitive instruments is not material. Wave's cash and cash equivalents consist primarily of
money market funds that meet high credit quality standards and the amount of credit exposure to any one issue is limited.

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. The quarterly financial information required by this Item 8 is included in the Notes to
Consolidated Financial Statements.

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

None.

41

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Item 9A.    Controls and Procedures



Our CEO and CFO have evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2007. Based on their evaluation, our CEO and
CFO have concluded, as of the date of such evaluation, that our disclosure controls and procedures are effective.



Wave's management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in
Rule 13a-15(f) promulgated under the Exchange Act. Wave's internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and
the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Wave's management assessed the effectiveness of its internal control over
financial reporting as of December 31, 2007. There has been no change in our internal controls over financial reporting that occurred during the period ended December 31, 2007 that has
materially affected, or is reasonably likely to materially affect, Wave's internal controls over financial reporting. In making its assessment, Wave's management used the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission in "Internal Control Integrated Framework". Based on this assessment, Wave's management concluded that, as of December 31, 2007,
its internal control over financial reporting is effective based on those criteria. The independent registered public accounting firm that audited the Company's consolidated financial statements
included elsewhere in this Annual Report on Form 10-K has issued an opinion of the effectiveness of the Company's internal control over financial reporting. That report appears
immediately following this report.

Dated:
March 17, 2008

WAVE
SYSTEMS CORP.

|By: |  | /s/STEVEN K. SPRAGUE |  | By:                                   |  | /s/GERARD T. FEENEY
|--- |  | -------------------- |  | ------------------------------------- |  | -------------------
|    |  | Name:                |  | Steven K. Sprague                     |  |                    
|    |  | Title:               |  | President and Chief Executive Officer |  |                    

Report of Independent Registered Public Accounting Firm

The
Board of Directors and Stockholders
Wave Systems Corp.:

We
have audited Wave Systems Corp.'s internal control over financial reporting as of December 31, 2007, based on criteria established inInternal
ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Wave Systems Corp.'s management is responsible
for maintaining effective internal control over financial reporting, included in the accompanyingManagement's Annual Report on Internal Control Over Financial
Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.

We
conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control
over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the

42

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design
and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.

A
company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures
that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

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

In
our opinion, Wave Systems Corp. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established
inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We
also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Wave Systems Corp. as of
December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders' equity (deficiency) and comprehensive income (loss), and cash flows for each of the years in the
three-year period ended December 31, 2007, and our report dated March 17, 2008 expressed an unqualified opinion on those consolidated financial statements and financial
statement schedule and included an explanatory paragraph that states that the Company has suffered recurring losses from operations and has an accumulated deficit that raise substantial doubt about
its ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of that uncertainty. Our report also included an
explanatory paragraph regarding the adoption of Statement of Financial Accounting Standards No. 123(R), "Share-Based Payment".

/s/
KPMG

Boston,
Massachusetts
March 17, 2008

Changes in internal controls

There have been no changes in Wave's internal controls over financial reporting that occurred during Wave's fourth fiscal quarter that have materially affected,
or are reasonably likely to affect, Wave's internal control over financial reporting.

Item 9B.    Other Information

Not Applicable.

43

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PART III

Item 10.    Directors and Executive Officers and Corporate Governance of the Registrant

Information concerning Wave's directors, executive officers, promoters and control persons will appear in Wave's Proxy Statement for the 2008 Annual Meeting of
Stockholders, to be filed pursuant to Regulation 14A on or before April 30, 2008, under the caption "Election of Directors." Such information is incorporated herein by reference.

Information
concerning compliance with Section 16(a) of the Securities Exchange Act will appear in Wave's Proxy Statement for the 2008 Annual Meeting of Stockholders, to be filed
pursuant to Regulation 14A on or before April 30, 2008, under the caption "Compliance with Section 16(a) of the Exchange Act." Such information is incorporated herein by
reference.

Information
concerning Wave's Audit Committee will appear in Wave's Proxy Statement for the 2008 Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A on or
before April 30, 2008, under the caption "The Board of Directors and its Committees" Such information is incorporated herein by reference.

Wave's
Board of Directors has adopted a code of ethics that applies to its Chief Executive Officer and Chief Financial Officer (the "Code of Ethics"). The Code of Ethics has been posted
on Wave's Internet website atwww.wave.com.Wave intends to satisfy the disclosure requirements under Item 10 of Form 8-K
regarding an amendment to, or waiver from, a provision of the Code of Ethics that relates to a substantive amendment or material departure from a provision of the Code of Ethics by posting such
information on its internet website atwww.wave.com.

Item 11.    Executive Compensation

Information regarding executive compensation will appear in Wave's Proxy Statement for the 2008 Annual Meeting of Stockholders, to be filed pursuant to
Regulation 14A on or before April 30, 2008, under the caption "Executive Compensation." Such information is incorporated herein by reference.

Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Information regarding security ownership of certain beneficial owners and management and related stockholder matters will appear in Wave's Proxy Statement for the
2008 Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A on or before April 30, 2008, under the caption "Security Ownership of Certain Beneficial Owners and
Management." Such information is incorporated herein by reference.

Item 13.    Certain Relationships and Related Transactions, and Director Independence

Information regarding certain relationships and related transactions and director independence will appear in Wave's Proxy Statement for the 2008 Annual Meeting
of Stockholders, to be filed pursuant to Regulation 14A on or before April 30, 2008, under the caption "Certain Relationships and Related Transactions." Such information is incorporated
herein by reference.

Item 14.    Principal Accountant Fees and Services

Information regarding Wave's principal accountant's fees will appear in Wave's Proxy Statement for the 2008 Annual Meeting of Stockholders, to be filed pursuant
to Regulation 14A on or before April 30,
2008, under the caption "Certain Relationships and Related Transactions." Such information is incorporated herein by reference.

44

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PART IV

Item 15.    Exhibits and Financial Statement Schedules

(a)(1)    Financial
Statements:

|                                                                                                                                                                |  | Page(s)
|--------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------
|Report of Independent Registered Public Accounting Firm                                                                                                         |  | F-1    
|Consolidated Balance Sheets as of December 31, 2007 and 2006                                                                                                    |  | F-2    
|Consolidated Statements of Operations for each of the years ended December 31, 2007, 2006 and 2005                                                              |  | F-3    
|Consolidated Statements of Stockholders' Equity (Deficiency) and Other Comprehensive Income (Loss) for each of the years ended December 31, 2007, 2006 and 2005 |  | F-4    
|Consolidated Statements of Cash Flows for each of the years ended December 31, 2007, 2006 and 2005                                                              |  | F-6    
|Notes to Consolidated Financial Statements                                                                                                                      |  | F-7    

(a)(2)    Financial
Statement Schedules:

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

(a)(3)    Exhibits:

|Exhibit No. |  |   |  | Description of Exhibit                                                                                                                                                                                                                                                  
|----------- |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1*        |  |  |  | Restated Certificate of Incorporation of Wave, as amended (incorporated by reference to Exhibit 3.1 of Wave's Quarterly Report on Form 10-Q, filed on August 9, 2006, File No. 0-24752)                                                                                 
|3.2*        |  |  |  | Bylaws of Wave (incorporated by reference to Exhibit 3.2 of Wave's Registration Statement on Form S-1, File No. 33-75286)                                                                                                                                               
|4.1*        |  |  |  | Form of Stock Certificate of Class A Common Stock (incorporated by reference to Exhibit 4.1 of Wave's Registration Statement on Form S-1, File No. 33-75286)                                                                                                            
|4.2*        |  |  |  | Form of Representative's Warrant Agreement, including the form of Representative's Warrant (incorporated by reference to Exhibit 4.2 of Wave's Registration Statement on Form S-1, File
No. 33-75286).                                                                  
|4.3*        |  |  |  | Certificate of Designation of Series B Preferred Stock of Wave as filed with the Delaware Secretary of State on May 24, 1996 (incorporated by reference to Exhibit 3.1 of Wave's Current Report on
Form 8-K, filed on June 6, 1996, File No. 0-24752)                   
|4.4*        |  |  |  | Certificate of Designation of Series C Convertible Preferred Stock as filed with the Delaware Secretary of State on December 27, 1996 (incorporated by reference to Exhibit 3.1 of Wave's Current Report on
Form 8-K, filed on January 8, 1997, File No. 0-24752)       
|4.5*        |  |  |  | Certificate of Designation of Series D Convertible Preferred Stock as filed with the Delaware Secretary of State on December 27, 1996 (incorporated by reference to Exhibit 3.1 of Wave's Current Report on
Form 8-K, filed on June 3, 1997, File No. 0-24752)          
|4.6*        |  |  |  | Certificate of Designation of Series F Convertible Preferred Stock of Wave as filed with the Delaware Secretary of State on October 9, 1997 (incorporated by reference to Exhibit 3.1 of Wave's Current Report
on Form 8-K, filed on October 15, 1997, File No. 0-24752)

45

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|4.7*    |  |  |  | Certificate of Designation of Series G Convertible Preferred Stock of Wave as filed with the Delaware Secretary of State on March 5, 1998 (incorporated by reference to Exhibit 3.1 of Wave's Current Report
on Form 8-K, filed on March 19, 1998, File No. 0-24752)
|------- |  | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|4.8*    |  |  |  | Certificate of Designation of Series H Convertible Preferred Stock of Wave as filed with the Delaware Secretary of State on April 30, 2003 (incorporated by reference to Exhibit 4.1 of Wave's Current Report
on Form 8-K, filed on May 5, 2003, File No. 0-24752)  
|4.9*    |  |  |  | Form of Warrant issued to Purchasers (incorporated by reference to Exhibit 4.1 of Wave's Current Report on Form 8-K, filed March 3, 2008, File # 0-24752)                                                                                                           
|4.10*   |  |  |  | Form of Warrant issued to Private Placement Agent (incorporated by reference to Exhibit 4.2 of Wave's Current Report on Form 8-K, filed March 3, 2008, File # 0-24752)                                                                                              
|10.2*   |  |  |  | Form of Subscription Agreement dated as of October 30, 2006 among Purchasers and Wave (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on October 31, 2006, File #
0-24752)                                                   
|10.3*   |  |  |  | Form of Subscription Agreement dated as of August 4, 2006 among Purchasers and Wave (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on August 8, 2006, File #
0-24752)                                                       
|10.4*   |  |  |  | Form of Subscription Agreement dated as of May 3, 2006 among Purchasers and Wave (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on May 8, 2006, File #
0-24752)                                                             
|10.5*   |  |  |  | Reserved                                                                                                                                                                                                                                                            
|10.6*   |  |  |  | Securities Purchase Agreement dated as of December 5, 2005 among Purchasers and Wave (includes form of warrant) (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on
December 7, 2005, File # 0-24752)                         
|10.7*   |  |  |  | Securities Purchase Agreement dated as of August 5, 2005 among Purchasers and Wave (includes form of warrant) (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on
August 8, 2005, File # 0-24752)                             
|10.8*   |  |  |  | Securities Purchase Agreement dated as of March 15, 2005 among Purchasers and Wave (includes form of warrant) (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on
March 17, 2005, File # 0-24752)                             
|10.9*  |  |  |  | Wave's Amended and Restated 1994 Stock Option Plan (incorporated by reference to Wave's Notice of Annual Meeting of Stockholders on Schedule 14A filed on April 18, 2007, as amended by the Schedule 14A filed
on May 7, 2007)                                      
|10.10* |  |  |  | Wave Non-Employee Directors Stock Option Plan (incorporated by reference to Wave's Notice of Annual Meeting of Stockholders on Schedule 14A filed on April 18, 2007, as amended by the Schedule 14A filed on
May 7, 2007)                                           
|10.11* |  |  |  | Wave 1996 Performance Stock Option Plan (incorporated by reference to Exhibit 10.12 of Wave's Annual Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                                                    
|10.12* |  |  |  | Employment Contract, dated June 8, 1998, between Gerard T. Feeney and Wave (incorporated by reference to Exhibit 10.18 of Wave's Annual Report on Form 10-K, filed on April 1, 1999, File
No. 0-24752).                                                             
|10.13* |  |  |  | Employment Contract, dated November 10, 1998, between Steven Sprague and Wave (incorporated by reference to Exhibit 10.19 of Wave's Annual Report on Form 10-K, filed on April 1, 1999, File
No. 0-24752).                                                          

46

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|10.14* |  |  |  | Asset Purchase Agreement dated August 13, 2000, by and among Wave and Indigo Networks, LLC (incorporated by reference to Exhibit 99.1 of Wave's Current Report on Form 8-K, filed on September 15,
2000, File #0-24752)                                                                             
|------ |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.15* |  |  |  | Office Building Lease dated October 20, 2002 between Stevens Creek Investors, LLC and Wave (incorporated by reference to Exhibit 10.13 of Wave's Annual Report on Form 10-K, filed on March 31, 2003,
 File #0-24752)                                                                               
|10.16* |  |  |  | Form of Asset Purchase Agreement dated October 4, 2001, by and between Wave and SignOnLine (incorporated by reference to Exhibit 10.15 of Wave's Annual Report on Form 10-K, filed on April 1, 2002, File
#0-24752)                                                                                 
|10.17* |  |  |  | First Amendment to Asset Purchase Agreement dated October 4, 2001, by and between Wave and SignOnLine (incorporated by reference to Exhibit 10.16 of Wave's Annual Report on Form 10-K, filed on April 1,
2002, File #0-24752)                                                                      
|10.18* |  |  |  | Termination Agreement and Mutual Release between Wave Systems Corp. and SSP Solutions, Inc. date September 30, 2002 (Incorporated herein by referenced to Exhibit 10.1 of Wave's Quarterly Report on
Form 10-Q for the quarter ended September 30, 2002, filed on November 14, 2002, File #0-24752) 
|10.19* |  |  |  | Subordinated Convertible Promissory Note between Wave Systems Corp. and SSP Solutions, Inc. dated September 30, 2002 (Incorporated herein by referenced to Exhibit 10.2 of Wave's Quarterly Report on
Form 10-Q for the quarter ended September 30, 2002, filed on November 14, 2002, File #0-24752)
|10.20* |  |  |  | Share Purchase Agreement between Redwave plc, GlobalWave Group plc and Wave Systems Corp. dated June 19, 2002 (Incorporated herein by referenced to Exhibit 10.3 of Wave's Quarterly Report on
Form 10-Q/A for the quarter ended September 30, 2002, filed on March 19, 2003, File #0-24752)        
|10.21* |  |  |  | GlobalWave Group plc Notice of Extraordinary General Meeting dated June 20, 2002 (Incorporated herein by referenced to Exhibit 10.4 of Wave's Quarterly Report on Form 10-Q/A for the quarter ended
September 30, 2002, filed on March 19, 2003, File #0-24752)                                     
|10.22* |  |  |  | Joint Venture Agreement dated October 15, 1999 between Wave, Wavexpress and Sarnoff. (incorporated by reference to Exhibit 10.20 of Wave's Annual Report on Form 10-K/A, filed on June 27, 2003, File
#0-24752)                                                                                     
|10.23* |  |  |  | Stockholder Agreement dated October 15, 1999 between Wave, Wavexpress and Sarnoff. (incorporated by reference to Exhibit 10.21 of Wave's Annual Report on Form 10-K/A, filed on June 27, 2003, File
#0-24752)                                                                                       
|10.24* |  |  |  | Securities Purchase Agreement dated as of July 30, 2004 among Purchasers and Wave (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on August 3, 2004, File
#0-24752)                                                                                          
|10.25* |  |  |  | Additional Investment Right to Purchase 3,529,412 Shares of Common Stock of Wave Systems Corp. (incorporated by reference to Exhibit 10.2 of Wave's Current Report on Form 8-K, filed on August 3, 2004, File
#0-24752)                                                                             
|10.26* |  |  |  | Series A Common Stock Purchase Warrant to Purchase 3,529,412 Shares of Class A Common Stock of Wave Systems Corp. (incorporated by reference to Exhibit 10.3 of Wave's Current Report on Form 8-K, filed
on August 3, 2004, File #0-24752)                                                          
|10.27* |  |  |  | Series B Common Stock Purchase Warrant to Purchase 882,353 Shares of Class A Common Stock of Wave Systems Corp. (incorporated by reference to Exhibit 10.4 of Wave's Current Report on Form 8-K, filed on
August 3, 2004, File # 0-24752)                                                           

47

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|10.28* |  |  |  | Placement Agency Agreement between Corpfin Inc. and Wave (incorporated by reference to Exhibit 10.5 of Wave's Current Report on Form 8-K, filed on August 3, 2004, File # 0-24752)                                                                                                 
|------ |  | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.29* |  |  |  | Subscription Agreement (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on May 5, 2006, File #0-24752)                                                                                                                                       
|10.30* |  |  |  | Subscription Agreement (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on August 8, 2006, File #0-24752)                                                                                                                                    
|10.31* |  |  |  | Subscription Agreement (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed on October 31, 2006, File #0-24752)                                                                                                                                  
|10.32* |  |  |  | Form of Subscription Agreement (incorporated by reference to Exhibit 99.1 of Wave's Current Report on Form 8-K, filed May 25, 2007, File # 0-24752)                                                                                                                                
|10.33* |  |  |  | Form of Subscription Agreement (incorporated by reference to Exhibit 10.1 of Wave's Current Report on Form 8-K, filed March 3, 2008, File # 0-24752)                                                                                                                               
|10.34* |  |  |  | Placement Agency Agreement, dated as of February 29, 2008, by and between Wave and Security Research Associates, Inc. (incorporated by reference to Exhibit 10.2 of Wave's Current Report on Form 8-K, filed
March 3, 2008, File # 0-24752)                                        
|21.1*  |  |  |  | Subsidiaries of Registrant (incorporated by reference to Exhibit 10.12 of Wave's Annual Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                                                                                
|23.1   |  |  |  | Consent of Independent Registered Public Accounting FirmKPMG LLP                                                                                                                                                                                                                  
|31.1   |  |  |  | Section 302 Certification by Steven K. Sprague, President and Chief Executive Officer                                                                                                                                                                                              
|31.2   |  |  |  | Section 302 Certification by Gerard T. Feeney, Chief Financial Officer                                                                                                                                                                                                             
|32.1   |  |  |  | Section 906 Certification                                                                                                                                                                                                                                                          
|99.1*  |  |  |  | Form of Series H Convertible Preferred Stock Purchase Agreement, dated as of April 30, 2003 (the "First Purchase Agreement"), by and among Wave and the purchasers of the Series H Convertible Preferred Stock
(Incorporated by reference to Wave's Form 8-K filed on May 5, 2003).
|99.2*  |  |  |  | Form of Series H Convertible Preferred Stock Purchase Agreement, dated as of April 30, 2003 (the "Second Purchase Agreement"), by and between Wave and an individual purchaser (Incorporated by reference to Wave's
Form 8-K filed on May 5, 2003).                                
|99.3*  |  |  |  | Form of Registration Rights Agreement by and among Wave and the purchasers of the Series H Convertible Preferred Stock, dated as of April 30, 2003 (Incorporated by reference to Wave's Form 8-K filed on
May 5, 2003).                                                            
|99.4*  |  |  |  | Form of Warrant issued by Wave pursuant to the First Purchase Agreement to each of the purchasers of the Series H Convertible Preferred Stock, dated as of April 30, 2003 (Incorporated by reference to Wave's
Form 8-K filed on May 5, 2003).                                     
|99.5*  |  |  |  | Form of Warrant issued by Wave pursuant to the Second Purchase Agreement to the individual purchaser, dated as of April 30, 2003 (Incorporated by reference to Wave's Form 8-K filed on May 5,
2003).                                                                              
|99.6*  |  |  |  | Form of Warrant issued by Wave to the placement agent and sub-placement agents, dated as of April 30, 2003 (Incorporated by reference to Wave's Form S-3 filed on May 14, 2003 (Registration
No. 333-99469)).                                                                      
|99.7*  |  |  |  | Letter Amendment to First Purchase Agreement and Second Purchase Agreement effected on August 11, 2003 (Incorporated by reference to Wave's Form 8-K filed on August 12, 2003).                                                                                                    

48

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|99.8*  |  |  |  | Form of Letter Agreement to the Series H Convertible Preferred Stock Purchase Agreements dated September 4, 2003, effected on September 15, 2003 (Incorporated by reference to Wave's Form 8-K filed on
September 16, 2003).                                            
|------ |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|99.9*  |  |  |  | Form of Waiver to the Series H Preferred Stock Purchase Agreements dated September 4, 2003, effected on September 15, 2003 (Incorporated by reference to Wave's Form 8-K filed on September 16,
2003).                                                                  
|99.10* |  |  |  | Securities Purchase Agreement, dated as of November 18, 2003, by and among Wave and purchasers of the Class A common stock. (Incorporated by reference to Wave's registration statement filed on Form S-3/A
filed on February 12, 2004. (Registration No. 333-112017.)) 
|99.11* |  |  |  | Form of Warrant issued by Wave to each of the purchasers of the Class A Common Stock and the placement agents, dated as of November 18, 2003 with the schedule of holders attached thereto. (Incorporated by
reference to Wave's Form 8-K/A filed on February 13, 2004).
|99.12* |  |  |  | Registration Rights Agreement by and among Wave and the purchasers of the Class A Common Stock, dated as of November 18, 2003. (Incorporated by reference to Wave's Form 8-K/A filed on February 13,
2004).                                                             
|99.13* |  |  |  | Demand Note, dated March 26, 2001 between Gerard T. Feeney and Wave (incorporated by reference to Exhibit 99.1 of Wave's Annual Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                             
|99.14* |  |  |  | Demand Note, dated February 27, 2001 between Peter J. Sprague and Wave (incorporated by reference to Exhibit 99.2 of Wave's Annual Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                          
|99.15* |  |  |  | Demand Note, dated July 25, 2001 between Peter J. Sprague and Wave (incorporated by reference to Exhibit 99.3 of Wave's Annual Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                              
|99.16* |  |  |  | Demand Note, dated September 5, 2001 between Peter J. Sprague and Wave (incorporated by reference to Exhibit 99.4 of Wave's Annual Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                          
|99.17* |  |  |  | Allonge to Demand Promissory Note, dated March 26, 2002 between Gerard T. Feeney and Wave (incorporated by reference to Exhibit 99.6 of Wave's Annual Report on Form 10-K/A, filed on June 30, 2003, File
#0-24752)                                                     
|99.18* |  |  |  | Allonge to Demand Promissory Note, dated February 27, 2002 between Peter J. Sprague and Wave (incorporated by reference to Exhibit 99.7 of Wave's Annual Report on Form 10-K/A, filed on June 30, 2003,
File #0-24752)                                                  
|99.19* |  |  |  | Allonge to Demand Promissory Note, dated July 25, 2002 between Peter J. Sprague and Wave (incorporated by reference to Exhibit 99.8 of Wave's Annual Report on Form 10-K/A, filed on June 30, 2003, File
#0-24752)                                                      

---

49

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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.

|Date: March 17, 2008 |  |                    |  |                                             
|-------------------- |  | ------------------ |  | --------------------------------------------
|                     |  | WAVE SYSTEMS CORP.
|                     |  | By:                |  | /s/STEVEN K. SPRAGUE                        
|                     |  |                    |  | Name: Steven K. Sprague                     
|                     |  |                    |  | Title: President and 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.

|Signature                                           |  | Title                                                                                                                                                                |  | Date          
|--------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------
|                                                    |  |                                                                                                                                                                      |  |               
|/s/STEVEN K. SPRAGUESteven K. Sprague               |  | President, Chief Executive Officer
and Director                                                                                                                      |  | March 17, 2008
|/s/JOHN E. BAGALAY, JR.John E. Bagalay, Jr.         |  | Chairman                                                                                                                                                             |  | March 17, 2008
|/s/GEORGE GILDERGeorge Gilder                       |  | Director                                                                                                                                                             |  | March 17, 2008
|/s/JOHN E. MCCONNAUGHY, JR.John E. McConnaughy, Jr. |  | Director                                                                                                                                                             |  | March 17, 2008
|/s/NOLAN BUSHNELLNolan Bushnell                     |  | Director                                                                                                                                                             |  | March 17, 2008
|/s/GERARD T. FEENEYGerard T. Feeney                 |  | Senior Vice President, Finance and
Administration, Chief Financial
Officer and Secretary (Principal
Financial Officer and Duly Authorized
Officer of the Registrant) |  | March 17, 2008

50

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The
Board of Directors and Stockholders
Wave Systems Corp.:

We
have audited the accompanying consolidated balance sheets of Wave Systems Corp. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of
operations, stockholders' equity (deficiency) and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2007. 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 the standards of the Public Company Accounting Oversight Board (United States). 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, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007 in conformity with
U.S. generally accepted accounting principles.

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

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

We
also have audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Wave Systems Corp.'s internal control over
financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) and our report dated March 17, 2008, expressed an unqualified opinion on the effective operation of internal control over financial reporting.

/s/
KPMG LLP

Boston,
Massachusetts
March 17, 2008

F-1

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WAVE SYSTEMS CORP. AND SUBSIDIARIES        Consolidated Balance Sheets        December 31, 2007 and 2006

|                                                                                                                                                |                                                                                                                             | 2007                       |              | 2006      |          
|----------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------ | --------- | ---------
|Assets                                                                                                                                          |                                                                                                                             |                            |              |           |          
|Current assets:                                                                                                                                 |                                                                                                                             |                            |              |           |          
|                                                                                                                                                | Cash and cash equivalents                                                                                                   |                            | $            | 3,714,030 |          
|                                                                                                                                                | Accounts receivable, net of allowance for doubtful accounts of $-0- and $40,547 at December 31, 2007 and 2006, respectively |                            |              | 1,165,385 |          
|                                                                                                                                                | Prepaid expenses                                                                                                            |                            |              | 339,342   |          
|                                                                                                                                                |                                                                                                                             |                            |              |           |          
|                                                                                                                                                |                                                                                                                             | Total current assets       |              |           | 5,218,757
|                                                                                                                                                | Property and equipment, net                                                                                                 |                            |              | 682,512   |          
|                                                                                                                                                | Other assets                                                                                                                |                            |              | 136,587   |          
|                                                                                                                                                |                                                                                                                             |                            |              |           |          
|Total Assets                                                                                                                                    |                                                                                                                             |                            | 6,037,856    |           |          
|                                                                                                                                                |                                                                                                                             |                            |              |           |          
|Liabilities and Stockholders' Equity                                                                                                            |                                                                                                                             |                            |              |           |          
|Current liabilities:                                                                                                                            |                                                                                                                             |                            |              |           |          
|                                                                                                                                                | Accounts payable and accrued expenses                                                                                       |                            |              | 3,253,320 |          
|                                                                                                                                                | Deferred revenue                                                                                                            |                            |              | 289,025   |          
|                                                                                                                                                |                                                                                                                             |                            |              |           |          
|                                                                                                                                                |                                                                                                                             | Total current liabilities  |              |           | 3,542,345
|                                                                                                                                                |                                                                                                                             |                            |              |           |          
|Stockholders' Equity:                                                                                                                           |                                                                                                                             |                            |              |           |          
|Common Stock, $.01 par value. Authorized 150,000,000 shares as Class A; 49,744,327 shares issued and outstanding in 2007 and 42,203,773 in 2006 |                                                                                                                             |                            | 497,443      |           |          
|Common Stock, $.01 par value. Authorized 13,000,000 shares as Class B; 38,232 shares issued and outstanding in 2007 and 39,232 in 2006          |                                                                                                                             |                            | 382          |           |          
|Capital in excess of par value                                                                                                                  |                                                                                                                             |                            | 325,481,336  |           |          
|Accumulated deficit                                                                                                                             |                                                                                                                             |                            | (323,483,650 | )         |          
|                                                                                                                                                |                                                                                                                             |                            |              |           |          
|                                                                                                                                                |                                                                                                                             | Total Stockholders' Equity |              |           | 2,495,511
|                                                                                                                                                |                                                                                                                             |                            |              |           |          
|Total Liabilities and Stockholders' Equity                                                                                                      |                                                                                                                             | $                          | 6,037,856    |           | $        
|                                                                                                                                                |                                                                                                                             |                            |              |           |          

See
accompanying notes to consolidated financial statements.

F-2

---





WAVE SYSTEMS CORP. AND SUBSIDIARIES        Consolidated Statements of Operations        Years ended December 31, 2007, 2006, 2005

|                    |                                                                      | 2007 |           | 2006        |   | 2005      |            
|------------------- | -------------------------------------------------------------------- | ---- | --------- | ----------- | - | --------- | -----------
|Net revenues:       |                                                                      |      |           |             |   |           |            
|Licensing           |                                                                      | $    | 6,223,487 |             | $ | 2,672,161 |            
|Services            |                                                                      |      | 83,473    |             |   | 444,220   |            
|                    |                                                                      |      |           |             |   |           |            
|                    | Total net revenues                                                   |      |           | 6,306,960   |   |           | 3,116,381  
|                    |                                                                      |      |           |             |   |           |            
|Cost of sales:      |                                                                      |      |           |             |   |           |            
|Licensing           |                                                                      |      | 781,675   |             |   | 700,766   |            
|Services            |                                                                      |      | 30,295    |             |   | 282,905   |            
|Hardware Products   |                                                                      |      |          |             |   |          |            
|                    |                                                                      |      |           |             |   |           |            
|                    | Total cost of sales                                                  |      |           | 811,970     |   |           | 983,671    
|                    |                                                                      |      |           |             |   |           |            
|                    | Gross profit                                                         |      |           | 5,494,990   |   |           | 2,132,710  
|                    |                                                                      |      |           |             |   |           |            
|Operating expenses: |                                                                      |      |           |             |   |           |            
|                    | Selling, general and administrative                                  |      |           | 15,222,896  |   |           | 12,598,389 
|                    | Research and development                                             |      |           | 10,557,937  |   |           | 8,486,368  
|                    |                                                                      |      |           |             |   |           |            
|                    | Total operating expenses                                             |      |           | 25,780,833  |   |           | 21,084,757 
|                    |                                                                      |      |           |             |   |           |            
|                    | Operating loss                                                       |      |           | (20,285,843 | ) |           | (18,952,047
|                    |                                                                      |      |           |             |   |           |            
|Other income:       |                                                                      |      |           |             |   |           |            
|                    | Interest income                                                      |      |           | 334,292     |   |           | 163,980    
|                    | Gain on sale of marketable securities                                |      |           |            |   |           |           
|                    | Unrealized gain on decrease in value of warrant liability            |      |           |            |   |           | 2,794      
|                    | Other income                                                         |      |           |            |   |           |           
|                    |                                                                      |      |           |             |   |           |            
|                    | Total other income                                                   |      |           | 334,292     |   |           | 166,774    
|                    |                                                                      |      |           |             |   |           |            
|                    | Net loss                                                             |      |           | (19,951,551 | ) |           | (18,785,273
|                    | Loss per common sharebasic and diluted                              |      | $         | (0.43       | ) | $         | (0.51      
|                    |                                                                      |      |           |             |   |           |            
|                    | Weighted average number of common shares outstanding during the year |      |           | 46,660,794  |   |           | 36,735,059 
|                    |                                                                      |      |           |             |   |           |            

See
accompanying notes to consolidated financial statements.

F-3

---





WAVE SYSTEMS CORP. AND SUBSIDIARIES
Consolidated Statements of Stockholders' Equity (Deficiency) And Comprehensive Income (Loss)

|                                                                                                             |                                                                   | Class A
Common Stock |   | Class B
Common Stock |         |   |         |   |   |      |   |   |            
|------------------------------------------------------------------------------------------------------------ | ----------------------------------------------------------------- | -------------------- | - | -------------------- | ------- | - | ------- | - | - | ---- | - | - | -----------
|
|
|
|Balance at December 31, 2004                                                                                 |                                                                   | 25,392,539           |   | $                    | 253,925 |   | 68,575  |   | $ | 686  |   | $ | 271,173,411
|Net loss                                                                                                     |                                                                   |                     |   |                      |        |   |        |   |   |     |   |   |           
|Unrealized Gain on Marketable Securities:                                                                    |                                                                   |                      |   |                      |         |   |         |   |   |      |   |   |            
|                                                                                                             | Unrealized holding gains during the period                        |                      |  |                      |         |  |         |  |   |      |  |   |            
|                                                                                                             | Less: reclassification adjustment for gain included in net income |                      |  |                      |         |  |         |  |   |      |  |   |            
|                                                                                                             |                                                                   |                      |   |                      |         |   |         |   |   |      |   |   |            
|Comprehensive loss                                                                                           |                                                                   |                     |   |                      |        |   |        |   |   |     |   |   |           
|Issuance of Class A Common Stock at $2.64 per share, net of issuance costs of $208,041                       |                                                                   | 1,553,030            |   |                      | 15,530  |   |        |   |   |     |   |   | 3,876,429  
|Issuance of Class A Common Stock at $2.70 per share, net of issuance costs of $210,975                       |                                                                   | 1,333,333            |   |                      | 13,333  |   |        |   |   |     |   |   | 3,375,872  
|Issuance of Class A Common Stock at $1.755 per share, less issuance cost of $159,110                         |                                                                   | 1,994,302            |   |                      | 19,943  |   |        |   |   |     |   |   | 3,320,947  
|Warrants Exercised at $3.39 per share, less issuance cost of $90,400                                         |                                                                   | 666,667              |   |                      | 6,667   |   |        |   |   |     |   |   | 2,162,933  
|Shares of Class A Common Stock Issued pursuant to the Wave Employee Stock Purchase Plan at $2.26 per share   |                                                                   | 84,492               |   |                      | 845     |   |        |   |   |     |   |   | 190,909    
|Shares of Class A Common Stock Issued pursuant to the Wave Employee Stock Purchase Plan at $2.04 per share   |                                                                   | 79,555               |   |                      | 796     |   |        |   |   |     |   |   | 161,497    
|Compensation cost for stock options granted to consultant                                                    |                                                                   |                     |   |                      |        |   |        |   |   |     |   |   | 7,294      
|Exchange of Class B Common Stock for Class A Common Stock                                                    |                                                                   | 10,000               |   |                      | 100     |   | (10,000 | ) |   | (100 | ) |   |           
|                                                                                                             |                                                                   |                      |   |                      |         |   |         |   |   |      |   |   |            
|Balance as of December 31, 2005                                                                              |                                                                   | 31,113,918           |   | $                    | 311,139 |   | 58,575  |   | $ | 586  |   | $ | 284,269,292
|Net loss                                                                                                     |                                                                   |                     |   |                      |        |   |        |   |   |     |   |   |           
|Issuance of Class A Common Stock at $1.605 per share, less issuance cost of $216,291                         |                                                                   | 2,782,866            |   |                      | 27,829  |   |        |   |   |     |   |   | 4,222,383  
|Issuance of Class A Common Stock at $2.40 per share, less issuance cost of $281,561                          |                                                                   | 2,012,500            |   |                      | 20,125  |   |        |   |   |     |   |   | 4,528,314  
|Issuance of Class A Common Stock at $2.05 per share, less issuance cost of $261,968                          |                                                                   | 2,336,752            |   |                      | 23,367  |   |        |   |   |     |   |   | 4,505,007  
|Issuance of Class A Common Stock at $2.73 per share, less issuance cost of $500,814                          |                                                                   | 3,517,230            |   |                      | 35,172  |   |        |   |   |     |   |   | 9,066,052  
|Shares of Class A Common Stock Issued pursuant to the Wave Employee Stock Purchase Plan at $1.9635 per share |                                                                   | 82,706               |   |                      | 827     |   |        |   |   |     |   |   | 161,566    
|Shares of Class A Common Stock Issued pursuant to the Wave Employee Stock Purchase Plan at $2.0145 per share |                                                                   | 62,269               |   |                      | 623     |   |        |   |   |     |   |   | 124,818    
|Warrants Exercised at $2.16 per share, less issuance cost of $14,000                                         |                                                                   | 162,037              |   |                      | 1,620   |   |        |   |   |     |   |   | 334,380    
|Warrants Exercised at $2.40 per share, less issuance cost of $11,000                                         |                                                                   | 114,583              |   |                      | 1,146   |   |        |   |   |     |   |   | 262,854    
|Cash paid for fraction shares in reverse stock split                                                         |                                                                   | (431                 | ) |                      | (4      | ) |        |   |   |     |   |   | (770       
|Stock based compensation                                                                                     |                                                                   |                     |   |                      |        |   |        |   |   |     |   |   | 1,556,042  
|Exchange of Class B Common Stock for Class A Common Stock                                                    |                                                                   | 19,343               |   |                      | 194     |   | (19,343 | ) |   | (194 | ) |   |           
|                                                                                                             |                                                                   |                      |   |                      |         |   |         |   |   |      |   |   |            
|Balance as of December 31, 2006                                                                              |                                                                   | 42,203,773           |   | $                    | 422,038 |   | 39,232  |   | $ | 392  |   | $ | 309,029,938

F-4

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES
Consolidated Statements of Stockholders' Equity (Deficiency) And Comprehensive Income (Loss) (Continued)

|                                                                                                             |  | Class A
Common Stock |  | Class B
Common Stock |         |  |        |   |   |     |   |   |            
|------------------------------------------------------------------------------------------------------------ |  | -------------------- |  | -------------------- | ------- |  | ------ | - | - | --- | - | - | -----------
|
|
|
|Balance as of December 31, 2006                                                                              |  | 42,203,773           |  | $                    | 422,038 |  | 39,232 |   | $ | 392 |   | $ | 309,029,938
|Net loss                                                                                                     |  |                     |  |                      |        |  |       |   |   |    |   |   |           
|Employee Stock Options Exercised at $2.43 per share                                                          |  | 3,315                |  |                      | 33      |  |       |   |   |    |   |   | 8,022      
|Issuance of Class A Common Stock at $2.05 per share, less issuance cost of $770,669                          |  | 7,317,073            |  |                      | 73,171  |  |       |   |   |    |   |   | 14,156,160 
|Shares of Class A Common Stock Issued pursuant to the Wave Employee Stock Purchase Plan at $1.8275 per share |  | 91,746               |  |                      | 917     |  |       |   |   |    |   |   | 166,748    
|Shares of Class A Common Stock Issued pursuant to the Wave Employee Stock Purchase Plan at $1.1985 per share |  | 127,420              |  |                      | 1,274   |  |       |   |   |    |   |   | 151,438    
|Exchange of Class B Common Stock for Class A Common Stock                                                    |  | 1,000                |  |                      | 10      |  | (1,000 | ) |   | (10 | ) |   |           
|Cash paid for fractional shares exchanged                                                                    |  |                     |  |                      |        |  |       |   |   |    |   |   | (241       
|Stock-based compensation                                                                                     |  |                     |  |                      |        |  |       |   |   |    |   |   | 1,969,271  
|                                                                                                             |  |                      |  |                      |         |  |        |   |   |     |   |   |            
|Balance as of December 31, 2007                                                                              |  | 49,744,327           |  | $                    | 497,443 |  | 38,232 |   | $ | 382 |   | $ | 325,481,336
|                                                                                                             |  |                      |  |                      |         |  |        |   |   |     |   |   |            

See accompanying notes to consolidated financial statements.

F-5

---





WAVE SYSTEMS CORP. AND SUBSIDIARIES        Consolidated Statements of Cash Flows        Years ended December 31, 2007, 2006, 2005

|                                                                            |                                                              | 2007 |             | 2006        |   | 2005        |            
|--------------------------------------------------------------------------- | ------------------------------------------------------------ | ---- | ----------- | ----------- | - | ----------- | -----------
|Cash flows from operating activities:                                       |                                                              |      |             |             |   |             |            
|Net loss                                                                    |                                                              | $    | (19,951,551 | )           | $ | (18,785,273 | )          
|Adjustments to reconcile net loss to net cash used in operating activities: |                                                              |      |             |             |   |             |            
|Depreciation and amortization                                               |                                                              |      | 355,884     |             |   | 663,033     |            
|                                                                            | Realized gain on marketable securities                       |      |             |            |   |             |           
|                                                                            | Gain on decrease in value of warrant liability               |      |             |            |   |             | (2,794     
|                                                                            | Compensation associated with issuance of stock options       |      |             | 1,969,271   |   |             | 1,556,042  
|Changes in assets and liabilities:                                          |                                                              |      |             |             |   |             |            
|                                                                            | (Decrease) increase in deferred revenue                      |      |             | (115,034    | ) |             | (99,571    
|                                                                            | Increase in accounts receivable                              |      |             | (529,533    | ) |             | (301,193   
|                                                                            | (Increase) decrease in prepaid expenses                      |      |             | (132,507    | ) |             | (67,149    
|                                                                            | (Increase) decrease in other assets                          |      |             | (5,315      | ) |             | 63,973     
|                                                                            | Increase (decrease) in accounts payable and accrued expenses |      |             | 217,971     |   |             | (53,801    
|                                                                            |                                                              |      |             |             |   |             |            
|                                                                            | Net cash used in operating activities                        |      |             | (18,190,814 | ) |             | (17,026,733
|Cash flows from investing activities:                                       |                                                              |      |             |             |   |             |            
|                                                                            | Acquisition of property and equipment                        |      |             | (618,672    | ) |             | (328,604   
|                                                                            | Proceeds provided by sale of marketable equity securities    |      |             |            |   |             |           
|                                                                            |                                                              |      |             |             |   |             |            
|                                                                            | Net cash provided by (used in) investing activities          |      |             | (618,672    | ) |             | (328,604   
|Cash flows from financing activities:                                       |                                                              |      |             |             |   |             |            
|                                                                            | Net proceeds from issuance of common stock                   |      |             | 14,229,331  |   |             | 22,428,249 
|                                                                            | Proceeds from employee options under stock plans             |      |             | 328,432     |   |             | 287,834    
|                                                                            | Proceeds from exercise of warrants                           |      |             |            |   |             | 600,000    
|                                                                            | Payment in lieu of fractional shares in reverse stock split  |      |             | (241        | ) |             | (774       
|                                                                            |                                                              |      |             |             |   |             |            
|                                                                            | Net cash provided by financing activities                    |      |             | 14,557,522  |   |             | 23,315,309 
|Net (decrease) increase in cash and cash equivalents                        |                                                              |      | (4,251,964  | )           |   | 5,959,972   |            
|Cash and cash equivalents at beginning of year                              |                                                              |      | 7,965,994   |             |   | 2,006,022   |            
|                                                                            |                                                              |      |             |             |   |             |            
|Cash and cash equivalents at end of year                                    |                                                              | $    | 3,714,030   |             | $ | 7,965,994   |            
|                                                                            |                                                              |      |             |             |   |             |            

See
accompanying notes to consolidated financial statements.

F-6

---





WAVE SYSTEMS CORP. AND SUBSIDIARIES        Notes to Consolidated Financial Statements

(1) Business of the Company

Wave Systems Corp. ("Wave" or "the Company") develops, produces and markets products for hardware-based digital security including security applications and
services that are complementary to and compliant with the specifications of the Trusted Computing Group,www.trustedcomputinggroup.org("TCG").
Specifications developed by the TCG are designed to address a broad range of current and evolving digital security issues facing the industry. These issues include the following: identity protection,
data security, digital signatures, electronic transaction integrity, platform trustworthiness, network security, and regulatory compliance. Wave's products are designed to solve many of these digital
security issues.

(2) Liquidity

The accompanying consolidated financial statements have been prepared assuming that Wave will continue as a going concern. Wave has incurred substantial operating
losses since its inception, and as of December 31, 2007, has an accumulated deficit of $323,483,650. Wave is expected to incur an operating loss for the calendar year of 2008. As of
December 31, 2007, we had working capital of $1,676,412.

Wave
has begun market introduction of its security and broadband media distribution software products and has signed initial distribution contracts for these applications. However, due
to the early stage nature of this market, it is unlikely that Wave will generate sufficient revenue to cover all of its cash flow needs to fund its operating requirements for the year ending
December 31, 2008.

Because
Wave does not have sufficient cash to fund operations for the year ending December 31, 2008; and given the uncertainties described above with respect to Wave's revenue
outlook for 2008, Wave has been and will continue to be actively engaged in financing activities in order to generate additional funding to cover its operating costs for the year ending
December 31, 2008. These activities included the filing of a $25,000,000 S-3 shelf registration with the SEC on March 20, 2007, which was declared effective on
April 27, 2007; and the subsequent sale of 7,317,073 shares of common stock pursuant to this shelf registration statement, for gross proceeds of $15,000,000 during 2007. Wave received net
proceeds of $14,229,331 from these sales of common stock after paying underwriter and other issuance costs totaling $770,669 in connection with the sale and issuance of these shares. An additional
$943,901 of gross proceeds under this shelf, are reserved for a warrant for the issuance of 365,853 shares of common stock at an exercise price of $2.58 per share. The warrant expires on
May 24, 2009. Also, on February 29, 2008, Wave sold an additional 3,173,500 shares of common stock pursuant to this shelf registration statement, for gross proceeds of $3,490,850. Wave
received net proceeds of approximately $3,221,000 from these sales of common stock after paying underwriter and other issuance costs totaling approximately $270,000 in connection with the sale and
purchase of these shares. $1,095,000 of gross proceeds under this shelf, are reserved for warrants issued to investors in the February 29, 2008 offering for the issuance of 952,050 shares of
common stock at an exercise price of $1.15 per share. These warrants expire on February 28, 2013. An additional $253,000 of gross proceeds are reserved for a warrant for the purchase of 190,410
shares of common stock at an exercise price of $1.33 per share issued to the placement agent in the February 29, 2008 offering. The placement agent warrant expires on February 28, 2010.
There remains approximately $4,411,000 in gross proceeds available under the March 20, 2007 shelf registration statement, which may be used for future financings although there can be no
assurances that future financings will be attainable.

F-7

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(2) Liquidity (Continued)

Also,
previously, on April 15, 2004 Wave filed a $25,000,000 registration statement with the SEC, under which Wave has drawn down a total of $22,494,000 in gross proceeds, through
various sales of common stock and issuances of warrants (See footnote 7).

Wave
will be required to sell additional shares of common stock, preferred stock, obtain debt financing or engage in a combination of these financing alternatives, to raise additional
capital to continue to fund its operations for the twelve months ending December 31, 2008.

Considering
current cash balances, Wave projects that it has enough liquid assets to continue operating into June 2008. Wave estimates a need of a minimum of $12,700,000 of additional
cash from a combination of revenue growth and additional financings, to fund operating expenses and capital expenditures for the year ending December 31, 2008.

If
Wave is not successful in raising the needed capital referred to above, or is not successful in executing its business plan, it could be forced to reduce expenses which may
significantly impede its ability to meet its sales, marketing and development objectives, cease operations or merge with another company. No assurance can be provided that any of these initiatives
will be successful. Due to its current cash position, capital needs over the next year and beyond, the fact that it has not at this time secured enough financing to fund operations through
December 31, 2008 and beyond, and the uncertainty as to whether it will achieve its sales forecast for its products and services, substantial doubt exists with respect to their ability to
continue as a going concern.

(3) Significant Accounting Policies

(a) Basis of Consolidation

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

(b) Use of Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect amounts reported in the Consolidated Financial Statements and accompanying notes. Estimates are used for, but not limited to, depreciation and
amortization, revenue recognition, accounts receivable reserves, valuation of long-lived and intangible assets, accounting for joint ventures, software development, contingencies and share based
compensation. Actual results could differ from those estimates.

(c) Method of Accounting for Joint Ventures

Wave accounts for its investments in joint ventures using the equity method of accounting when its ownership interest in the joint venture is less than fifty
percent and it is determined that Wave has the ability to exercise significant influence over the joint venture's operating and financial policies. The financial statements of joint ventures in which
Wave owns greater than a fifty percent interest are consolidated with Wave's financial statements (see note 10).

F-8

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(3) Significant Accounting Policies (Continued)

(d) Cash and Cash Equivalents

Wave considers all highly liquid instruments with an original or remaining maturity of three months or less to be cash equivalents. Substantially all cash and
cash equivalents are custodial with two major financial institutions.

(e) Marketable Securities

Investments, which consist solely of equity securities, are accounted for under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for
Certain Investments in Debt and Equity Securities" issued by the Financial Accounting Standards Board (FASB). Pursuant to the provisions of SFAS No.115, investments are classified as "trading",
"available-for sale" or "held to maturity". "Trading" securities are bought and held principally for the purpose of selling them in the near term and are recorded at fair value. Fair value
is based upon quoted market prices. Unrealized gains and losses on trading securities are included in the determination of net earnings. "Available-for-sale" securities are
being held for an unspecified period of time and may be used for liquidity or other corporate purposes and are recorded at fair value. Unrealized gains and losses on
available-for-sale securities are reported as a separate component of comprehensive income (loss) in stockholders' equity. Unrealized losses that are determined to be other
than temporary are recognized as charges against earnings. Factors considered when determining if an other than temporary decline has occurred include: whether a decline in market value is related to
specific concerns of the issuer of the securities as opposed to general market conditions, the length of time of the decline in market price, the financial condition and near-term
prospects of the issuer and other factors that may indicate that the value of the securities will not recover. "Held to maturity" securities are debt securities that are intended to be held to
maturity and are recorded at amortized cost. Wave held no marketable securities as of December 31, 2007 and 2006.

(f) Accounts Receivable and Allowance For Doubtful Accounts

Included in accounts receivable at December 31, 2007 and 2006 are amounts unbilled totaling $327,988 and $147,260, respectively.

The
determination of the allowance for doubtful accounts is based on management's estimate of uncollectible accounts receivable. Management records specific reserves for receivable
balances that are considered high risk due to known facts regarding the customer.

(g) Concentrations of Credit Risks

Sales to Wave's largest customer in 2007 and 2006, Dell, Inc., were approximately 71% and 35% of revenue, respectively. Accounts receivable at
December 31, 2007 and 2006 included receivables from Dell, Inc. of $652,572 and $272,825, respectively. Sales to their largest customer in 2005, ST Microelectronics, were approximately
44% of revenue. Accounts receivable at December 31, 2005 included receivables from ST Microelectronics of $144,373.

(h) Property and Equipment

Property and equipment, including purchased computer software, are stated at cost less accumulated depreciation and amortization. Depreciation and amortization
are computed using the

F-9

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(3) Significant Accounting Policies (Continued)

straight-line
method over the estimated useful lives of the assets which range from between three to five years. Amortization of leasehold improvements is computed using the shorter of the
useful life or remaining lease term.

(i) Income Taxes

Effective January 1, 2007, Wave adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxesand interpretation of
FASB Statement 109" ("FIN 48"), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken, or expected
to be taken, in a tax return, and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transition. The adoption of FIN 48
did not result in a cumulative adjustment to Wave's accumulated earnings. Wave classifies any interest and penalties related to income taxes as components of the income tax provision.

Wave
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. At December 31, 2007 and 2006, a full valuation allowance has been
recorded against the gross deferred tax asset since management believes that, after considering all the available objective evidence, both positive and negative, historical and prospective, with
greater weight given to historical evidence, it is more likely than not that these assets will not be realized.

(j) Share-based Payments

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

SFAS
No. 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the
award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company's consolidated statement of operations. SFAS No. 123(R) supersedes Wave's
previous accounting under the provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." As permitted by SFAS No. 123, Wave measured compensation cost for options granted
prior to January 1, 2006, in accordance with Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees" and related interpretations. Accordingly, no
accounting recognition was given to stock options granted at fair market value until they were exercised. Upon exercise, net proceeds, including tax benefits realized, were credited to equity.

F-10

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(3) Significant Accounting Policies (Continued)

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

(k) Research and Development and Software Development Costs

Research and development costs are expensed as incurred. Software development costs are accounted for pursuant to Statement of Financial Accounting Standards
No. 86 "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed" which requires software development costs for products that have achieved commercial
marketability to be capitalized subsequent to the establishment of a product's technological feasibility and prior to general release of the product. Wave did not capitalize any software development
costs for 2007 or 2006. Amortization of capitalized software costs for the years ended December 31, 2007, 2006 and 2005 was $69,733, $382,287 and $621,419, respectively.

(l) 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. Diluted net
loss per share is also computed using the weighted average number of common shares and excludes dilutive potential common shares outstanding, as their effect is anti-dilutive. Dilutive
potential common shares consist primarily of employee stock options and stock warrants. Diluted net loss per share is equal to basic net loss per share and is therefore not presented separately in the
financial statements. The weighted average number of potential common shares that would have been included in diluted loss per share had their effect not been anti-dilutive for each of the
years ended December 31, 2007, 2006 and 2005 were approximately 175,000 shares, 121,000 shares and 67,000 shares, respectively. Employee stock options and other stock warrants to purchase
approximately 6,446,000, 5,577,000 and 5,515,000 shares were outstanding for the years ended December 31, 2007, 2006 and 2005 respectively, but are not included in the computation of diluted
loss per share because their exercise price was greater than the average share price of Wave's common shares and, therefore, their effect would have been anti-dilutive.

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

Wave reviews the valuation of long-lived assets, including property and equipment and capitalized software, under the provisions of SFAS
No. 144,"Accounting for the Impairment or Disposal of Long-Lived Assets"("SFAS No. 144") and SFAS No.86, "Accounting for the Costs of Computer Software to Be Sold,
Leased, or Otherwise Marketed"("SFAS No. 86"), respectively. Wave is required to
assess the recoverability of long-lived assets and capitalized software development costs whenever events and circumstances indicate that the carrying value may not be recoverable. Factors
considered important that could trigger an impairment review include the following:



F-11

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(3) Significant Accounting Policies (Continued)



In
accordance with SFAS No. 144, when Wave determines that the carrying value of applicable long-lived assets may not be recoverable based upon the existence of one or
more of the above indicators of impairment, they evaluate whether the carrying amount of the asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual
disposition of that asset. If such a circumstance exists, Wave would measure an impairment loss to the extent the carrying amount of the particular long-lived asset or group exceeds its
fair value. Wave would determine the fair value based on a projected discounted cash flow method using a discount rate determined by management to be commensurate with the risk inherent in their
current business model. In accordance with SFAS No. 86, when Wave determines that the carrying value of capitalized software development costs may not be recoverable, they evaluate whether the
unamortized cost exceeds the expected future net realizable value of the products. If the unamortized costs exceed the expected future net realizable value of the products, the excess amount is
written off. Changes in judgments on any of these factors could impact the value of the asset being evaluated.

(n) Revenue Recognition

Wave's business model targets revenues from various sources including: licensing of EMBASSY Trust Suite, Wavexpress' broadband media distribution and eTMS
software products and development contracts. Many of these sales arrangements include multiple-elements, and/or required significant modification or customization of Wave's software.

Wave
follows the provisions of statement of position "SOP" 97-2,Software Revenue Recognitionas amended by
SOP 98-9, Modification of SOP 97-2,Software Revenue Recognition, with Respect to Certain Transactions. Generally,
Wave recognizes revenue when it is realized or realizable and earned. Wave considers revenue realized or realizable and earned when persuasive evidence of an arrangement exists, delivery has occurred,
the sales price is fixed or determinable and collectability is reasonably assured. Wave reduces revenue for estimated customer returns, rotations and sales rebates when such amounts can be estimated.
When these amounts cannot be estimated Wave defers revenue until the product is sold to the end-user. Revenue from software license agreements that have significant customizations and
modification of the software product is deferred and recognized in a manner that approximates the percentage of completion
method. In addition to the aforementioned general policy, the following are the specific revenue recognition policies for each major category of revenue.

PRODUCTSSOFTWARE

Revenue from delivered elements of one-time charge licensed software is recognized at the inception of the license term, provided Wave has
vendor-specific objective evidence of the fair value of each undelivered element, for arrangements that contain multiple elements. Revenue is deferred for undelivered elements for these arrangements.
Revenue is also deferred for the entire arrangement, if vendor-specific objective evidence does not exist for each undelivered contract element. Examples of undelivered elements in which the timing of
delivery is uncertain include contractual elements that give customers rights to any future upgrades at no additional charge or future maintenance that is provided within the overall price. The
revenue that is deferred for any contract element is recognized when all of the revenue recognition criteria have been met for that element.

F-12

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(3) Significant Accounting Policies (Continued)

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

SERVICES

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

(o) Accounting for Warrants Containing Cash Settlement Provisions

Wave follows the FASB's Emerging Issues Task Force pronouncement No. 00-19 ("EITF 00-19") to account for derivative
financial instruments indexed to, and settled in our own stock. These would include financial instruments such as options or warrants to purchase Wave stock, but does not include employee stock
options. EITF 00-19 requires that freestanding financial instruments of this nature be classified as an asset or liability at fair value, in the event that the contract underlying
any such financial instruments includes a net cash settlement provision. In addition, EITF 00-19 requires any such asset or liability to be marked to market at the end of each
period, with any resulting difference in fair value to be recorded as income or loss, through the company's statement of operations, depending upon whether the difference results in a gain or loss.

(p) Recent Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial
LiabilitiesIncluding an amendment of FASB Statement No. 115(SFAS No. 159). SFAS No. 159 permits entities to elect to measure financial assets
and financial liabilities, and certain other items at fair value. SFAS No. 159 is effective as of the beginning of the first fiscal year that begins after November 15, 2007, and
therefore its provisions will be applied for the Company on January 1, 2008. Wave does not expect the implementation of SFAS No. 159 to have a material impact on the Company's
consolidated financial statements.

In
September 2006, the FASB issued SFAS No. 157,Fair Value Measurements (SFAS No. 157). This Statement defines fair value,
establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and therefore its provisions will be adopted by Wave on January 1, 2008. Wave does not expect the implementation of
SFAS No. 157 to have a material impact on the Company's consolidated financial statements.

In
November 2007, the EITF reached a consensus on EITF Issue No. 07-1,Accounting for Collaborative Arrangements(EITF 07-1). EITF 07-1 provides guidance on the identification of collaborative arrangements and establishes reporting requirements for transactions between
participants in a collaborative arrangement and between participants in the arrangement and third parties. EITF 07-1 is effective for fiscal years beginning after
December 15, 2008, and interim periods within

F-13

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(3) Significant Accounting Policies (Continued)

those
financial years, and therefore would be effective for Wave beginning January 1, 2009. Wave is evaluating the impact EITF 07-1 will have on its consolidated financial
statements.

In
December 2007, the FASB issued Financial Accounting Standards Board Statement (FAS) No. 141 (R)," Business Combinations," (FAS 141R), which requires most
identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at "full fair value." Under FAS 141R, all business
combinations will be accounted for under the acquisition method. Significant changes, among others, from current guidance resulting from FAS 141R includes the requirement that contingent assets
and liabilities and contingent consideration shall be recorded at estimated fair value as of the acquisition date, with any subsequent changes in fair value charged or credited to earnings. Further,
acquisition-related costs will be expensed rather than treated as part of the acquisition. FAS 141R is effective for periods beginning on or after December 15, 2008. We expect the
adoption of FAS 141R will increase costs charged to operations.

In
December 2007, the FASB issued SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB
No. 51(SFAS No. 160). SFAS 160 amends ARB No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary
and for the deconsolidation of a subsidiary, in which the noncontrolling interest will be reclassified as equity; and the income, expense and comprehensive income from a noncontrolling interest will
be fully consolidated. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008, and therefore would be effective
for Wave beginning January 1, 2009. Wave is evaluating the impact SFAS 160 will have on its consolidated financial statements.

(4) Related Party Transactions

In March 2003, Mr. Peter Sprague, who is the former Chairman of Wave, was appointed Chairman and Chief Executive Officer of Wavexpress. Mr. Sprague
was paid $129,000 for each of the years ended December 31, 2007, 2006 and 2005, respectively in salary as an officer of Wavexpress. Mr. Peter Sprague is the father of Wave's President
and Chief Executive Officer, Steven Sprague.

On
August 1, 1997, Michael Sprague became an employee of Wave and was paid a salary of $187,500, $150,000 and $150,000 for the years ended December 31, 2007, 2006 and 2005,
respectively. In addition, lease payments were made to Michael Sprague in the amount of $48,750 for the year ended December 31, 2006. These payments were for property occupied by Wavexpress and
owned by Michael Sprague. This lease agreement was in effect for the period of April 15, 2006 through October 31, 2006. Michael Sprague is the brother of Steven Sprague and the son of
Wave's former Chairman, Peter Sprague.

F-14

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(5) Property and Equipment

Property and equipment as of December 31 consisted of the following:

2007

2006Computer equipment

$
3,806,573

$
3,308,529Furniture, fixtures and improvements


298,843


231,162Computer software


2,529,673


2,502,0546,635,089


6,041,745Less: Accumulated depreciation and amortization


5,952,577


5,622,021Total

$
682,512

$
419,724


Computer
software includes $1,864,256 of capitalized software development costs pursuant to SFAS 86 as of December 31, 2007 and 2006. Capitalized software pursuant to
SFAS 86 is amortized over a three-year life using the straight-line method, once the product is ready to bring to market. Capitalized software is fully amortized at
December 31, 2007.

Depreciation
and amortization expense on property and equipment amounted to approximately $356,000, $663,000 and $842,000 for the years ended December 31, 2007, 2006, 2005,
respectively.

(6) Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses as of December 31 consisted of the following:

2007

2006Accounts payable

$
747,737

$
910,935Accrued consulting and professional fees


405,289


351,083Accrued payroll and related costs


1,433,417


1,232,924State & local taxes payable


296,784


173,539Accrued software licenses


162,500


162,500Other accrued expenses


207,593


204,368Total accounts payable and accrued expenses

$
3,253,320

$
3,035,349


(7) Common Stock

On May 24, 2007, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 7,317,073 shares of Class A Common
Stock, par value $0.01 per share, to certain purchasers for an aggregate purchase price of $15,000,000. These shares were priced at $2.05 per share. Securities Research Associates, Inc. ("SRA")
entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of
this offering. Wave also agreed to issue a warrant to SRA to purchase up to 365,853 shares of Class A common stock at an exercise price of $2.58 per share. The Warrant expires on May 24,
2009. Wave realized net proceeds of approximately $14,229,331 after deducting the placement agent fees of $750,000 and additional legal and other fees associated with the issuance of these securities
which totaled $20,669. The shares sold on May 24, 2007 were offered and issued pursuant to a shelf registration statement which was filed by Wave on March 20, 2007 and declared effective
by the Commission on April 27, 2007.

F-15

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(7) Common Stock (Continued)

On
October 30, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 3,517,230 shares of Class A Common Stock, par value $.01 per
share, to certain purchasers for an aggregate purchase price of $9,602,038. These shares were priced at $2.73 per share. Securities Research Associates, Inc. ("SRA") entered into a placement
agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering. Wave also
agreed to issue a warrant to SRA to purchase up to 175,861 shares of Class A common stock at an exercise price of $2.73. The warrant expired unexercised on November 30, 2007. Wave
realized net proceeds of $9,101,224 after deducting the placement agent fees of $484,000 and additional legal and other fees associated with the issuance of the securities which totaled $16,814. The
shares sold on October 30, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and declared effective by the Commission
on January 13, 2006.

On
August 4, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 2,336,752 shares of Class A Common Stock, par value $.01 per
share, to certain purchasers for an aggregate purchase price of $4,790,342. These shares were priced at $2.05 per share. Securities Research Associates, Inc. ("SRA") entered into a placement
agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a fee equal
to 5.0% of the gross proceeds of this offering. Wave also agreed to issue a warrant to SRA to purchase up to 116,837 shares of Class A common stock at an exercise price of $2.05. The warrant
expired unexercised on September 3, 2007. Wave realized net proceeds of $4,528,374 after deducting the placement agent fees of $239,517 and additional legal and other fees associated with the
issuance of these securities which totaled $22,451. The shares sold on August 4, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on
December 16, 2005 and declared effective by the Commission on January 13, 2006.

On
May 8, 2006, Wave received gross proceeds of $625,000 less placement agent fees of $25,000 for net proceeds of $600,000, in connection with the issuance of 276,620 shares of
Class A Common Stock upon the exercise of two warrants that were granted to an investor as part of Wave's December 5, 2005 financing and February 15, 2006 financing. The warrant
issued to this investor in connection with the December 5, 2005 financing was exercised in full for 114,583 shares of Class A Common Stock at an exercise price of $2.40 per share. The
warrant issued to the investor in connection with the February 15, 2006 financing was exercised in full for 162,037 shares of Class A Common Stock at an exercise price of $2.16 per
share. The shares sold on May 8, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and declared effective by the
Commission on January 13, 2006.

On
May 3, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 2,012,500 shares of Class A Common Stock to certain purchasers
for an aggregate purchase price of $4,830,000. The shares were priced at $2.40 per share. SRA entered into a placement agency agreement with Wave in which they agreed to act as placement agent in
connection with the offering. Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering. Wave also agreed to issue a warrant to SRA to purchase up to 100,625 shares of
Class A common stock at an exercise price of $2.40. The warrant expired unexercised on June 3, 2007. Wave realized net proceeds of $4,548,439 after deducting the placement agent fees of
$241,500 and additional legal and other fees associated with the issuance of these securities, which were $40,061. The shares sold on May 3, 2006

F-16

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(7) Common Stock (Continued)

were
offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and declared effective by the Commission on January 13, 2006.

On
February 15, 2006, Wave entered into a securities purchase agreement, pursuant to which Wave agreed to sell and issue 2,782,866 shares of Class A Common Stock for $1.605
per share, to certain purchasers for an aggregate purchase price of $4,466,500. The purchasers were also granted warrants (the "Warrants") to purchase up to 516,956 shares of Class A common
stock at an exercise price of $2.16. The Warrants were exercisable for a period of six months following the date of issuance. Warrants to purchase 162,037 shares were exercised on May 8, 2006,
as described above. The remaining warrants to purchase 354,919 shares expired unexercised on August 16, 2006. Each Warrant was subject to cancellation if the closing bid price of Wave's common
stock exceeded $2.58 for 10 out of 20 consecutive trading days and the Warrant had not been exercised by the close of business on the trading day after the 10th trading day on which the closing
bid price exceeded $2.58. The placement agent, JPC Capital Partners, Inc. (formerly Corpfin, Inc.) (the "Placement Agent") had entered into a placement agency agreement with Wave in
which they agreed to act as placement agent in connection with the offering. Wave agreed to pay the Placement Agent a fee equal to 4.0% of the gross proceeds
of this offering. Wave realized net proceeds of $4,250,212 after deducting the placement agent fees of $216,291 and additional legal and other fees associated with the issuance of these securities.
The shares sold on February 15, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and declared effective by the
Commission on January 13, 2006.

On
December 5, 2005, Wave entered into a Securities Purchase Agreement, pursuant to which Wave sold and issued 1,994,302 shares of Class A Common Stock, par value $.01 per
share, to certain purchasers who are parties to the Purchase Agreement for an aggregate purchase price of $3,500,000. The Common Shares were priced at $1.755 per share. JPC Capital
Partners, Inc. (formerly Corpfin Inc.) (the "Placement Agent"), had entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with
the offering. Wave paid the Placement Agent a fee equal to 4.0% of the gross proceeds of this offering. Wave realized net proceeds of $3,340,890 after deducting placement agent and other fees
associated with the issuance of these securities. The shares sold on December 5, 2005 were offered and issued pursuant to a shelf registration statement which was filed by Wave on
April 15, 2004 and declared effective by the Commission on May 10, 2004.

On
August 5, 2005, Wave entered into a securities purchase agreement, pursuant to which Wave agreed to sell and issue 1,333,333 shares of Class A Common Stock, par value
$.01 per share, for $2.70 per share, to certain purchasers who are parties to the Purchase Agreement for an aggregate purchase price of $3,600,000. The Placement Agent had entered into a placement
agency agreement with Wave in which they agreed to act as a placement agent in connection with the offering. Wave has agreed to pay the Placement Agent a fee equal to 4.0% of the gross proceeds of
this offering. Wave realized net proceeds of $3,389,205 after deducting the placement agent fees of $144,000 and additional legal and other fees associated with the issuance of these securities of
$66,795. The shares sold on August 5, 2005 were offered and issued pursuant to a shelf registration statement which was filed by Wave on April 15, 2004 and declared effective by the
Commission on May 10, 2004.

On
August 1, 2005, Wave received gross proceeds of $2,260,000 less placement agent fees of $90,400 for net proceeds of $2,169,600, for the issuance of 666,667 shares of
Class A Common Stock upon partial exercise of a warrant that was granted to an accredited investor as part of a securities

F-17

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(7) Common Stock (Continued)

purchase
agreement with the accredited investor, dated July 30, 2004. The warrants were exercised at a price of $3.39 per share.

On
March 15, 2005, Wave entered into a securities purchase agreement, pursuant to which Wave sold and issued 1,553,030 shares of Class A Common Stock, par value $.01 per
share for an aggregate purchase price of $4,100,000. The shares of Class A Common Stock were priced at $2.64. The Placement Agent, had entered into a placement agency agreement with Wave in
which they agreed to act as placement agent in connection with the offering. Wave paid the placement agent a fee equal to 4% of the gross proceeds of this offering. Wave realized net proceeds of
$3,891,959 after deducting placement agent and other fees associated with the issuance of these securities, which totaled $208,041. The shares sold on March 15, 2005 were offered and issued
pursuant to a shelf registration statement which was filed by Wave on April 15, 2004 and declared effective by the Commission on May 10, 2004.

On
December 1, 2007 Wave issued 127,420 shares of Class A Common Stock to Wave and Wavexpress employees for $1.20 per share, pursuant to the Wave 2004 Employee Stock
Purchase Plan. Wave received proceeds of $152,712, from the sale of these shares.

On
June 1, 2007 Wave issued 91,746 shares of Class A Common Stock to Wave and Wavexpress employees for $1.83 per share, pursuant to the Wave 2004 Employee Stock Purchase
Plan. Wave received proceeds of $167,665, from the sale of these shares.

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

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

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

On
June 1, 2005 Wave sold 84,492 shares of Class A Common Stock to Wave and Wavexpress employees for $2.26 per share, pursuant to the Wave 2004 Employee Stock Purchase
Plan. Wave received proceeds of $191,754, from the sale of these shares.

F-18

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(8) Share-based Compensation

In January 1994, Wave adopted the 1994 Employee Stock Option Plan (the "1994 Plan"). The total number of shares of Class A Common Stock reserved for
issuance under the 1994 Plan, as amended is 10,500,000 shares. The 1994 Plan Expires on July 1, 2014. In September 1996, Wave adopted the 1996 Performance Stock Option Plan (the "1996 Plan").
The number of shares of Class A Common Stock subject to the 1996 Plan was 266,666. Under 1994 and 1996 Plans, both incentive stock options and non-qualified stock options may be
granted to officers, key employees and other persons providing services to Wave. Options granted under the plans generally vest over three years and expire ten years from the date of grant. In January
1994, Wave adopted the Non-Employee Directors Stock Option Plan (the "Directors' Plan"). The total number of shares of Class A Common
Stock reserved for issuance under the Directors' Plan, as amended, is 1,000,000 shares. Under the Directors' Plan, as amended, each director who is not an employee of Wave receives an initial grant of
options to purchase 12,000 shares of Class A Common Stock; and an additional annual grant to purchase 10,000 shares on the day immediately following each of the dates on which an incumbent
director is reelected. The options granted to non-employee directors vest on the day following the grant and expire ten years from the date of grant. Under all of Wave's stock option
plans, options are granted with exercise prices that approximate fair market value at the date of grant. All of Wave's stock option plans and amendments thereto have been approved by shareholder vote.

In
November 2004 Wave adopted the 2004 Employee Stock Purchase Plan (the "Purchase Plan") pursuant to which a total of 1,000,000 shares of Wave's Common Stock may be sold to eligible
employees at a 15% discount from the market value of the shares. The Purchase Plan was approved by a vote of Wave's shareholders. Under the terms of the Purchase Plan, employees may elect to have
withheld up to 15% of their base earnings to purchase these shares during each offering period, up to a maximum of $25,000 in market value of Wave Common Stock. Offering periods commence on
May 1st and December 1st and are for a period of six months. The purchase price under the Purchase Plan is 85% of the lesser of the market price on the beginning or the
ending of the offering period. On January 1, 2006, Wave adopted Statement of Financial Accounting Standards No. 123(R), "Share-Based Payment," ("SFAS No. 123(R)"), which requires
the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options and employee stock purchases based on
estimated fair values. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 ("SAB 107") relating to SFAS No. 123(R). The Company has
applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

SFAS
No. 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the
award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company's consolidated statement of operations. SFAS No. 123(R) supersedes Wave's
previous accounting under the provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." As permitted by SFAS No. 123, Wave measured compensation cost for options granted
prior to January 1, 2006, in accordance with Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25") and related
interpretations. Accordingly, no accounting recognition was given to stock options granted at fair market value until they were exercised. Upon exercise, net proceeds, including tax benefits realized,
were credited to equity.

Wave
adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006. In
accordance with the modified prospective transition method, Wave's consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS
No. 123(R). Stock-based compensation

F-19

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(8) Share-based Compensation (Continued)

expense
recognized under SFAS No. 123(R) for the years ended December 31, 2007 and 2006 was $1,969,271 and $1,556,042, respectively. Stock-based compensation expense for the year ended
December 31, 2005 under APB No. 25 and the related interpretations was $7,294. SFAS 123(R) requires that the classification of the cost of share based compensation, in the
statement of operations, is consistent with the nature of the services being rendered in exchange for the share based payment.

The
following table summarizes the effect of share based compensation in Wave's statement of operations for the years ended December 31:

2007

2006Cost of Sales

$
19,247

$
25,577Selling, General & Administrative


1,230,392


1,056,012Research & Development


719,632


474,453Total

$
1,969,271

$
1,556,042


Wave
uses the Black-Scholes-Merton option pricing model to value stock options. The Black-Scholes-Merton model requires the use of employee exercise behavior data and the use of a number
of assumptions including volatility of the company's stock price, the weighted-average risk-free interest rate and the weighted-average expected term of the options. As Wave does not pay
dividends, the dividend rate variable in the Black-Scholes-Merton model is zero. The following values for the indicated variables were used to value options granted during the years ended
December 31:

|                             |  | 2007          |  | 2006          
|---------------------------- |  | ------------- |  | --------------
|
|Expected Term (in years)     |  | 5 Years       |  | 6 Months      
|Risk-free Raterange         |  | 3.49%  5.07% |  | 3.28%  4.98% 
|Risk-free Ratewt. avg.      |  | 4.66%         |  | 4.88%         
|Expected Volatilityrange    |  | 92.2%  95.0% |  | 44.9%  71.31%
|Expected Volatilitywt. avg. |  | 93.93%        |  | 58.35%        
|Dividend Yield               |  | 0%            |  | 0%            

The
volatility assumptions are based on the historical weekly price data of Wave's stock over a period equivalent to the weighted average expected term of the options. Management did not
identify any factors during that period which were unusual and which would distort the volatility figure if used to estimate future volatility.

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

The
expected term of employee stock options represents the weighted average period that the stock options are expected to remain outstanding. For Wave's stock option plans, it is based
upon an analysis of the historical behavior of option holders during the period from January 1, 2001 to December 31, 2006. Management believes historical data is representative of future
exercise behavior. For Wave's Employee Stock Purchase Plan, the expected term of six months, is the length of each purchase period, pursuant to the plan.

F-20

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(8) Share-based Compensation (Continued)

As
stock-based compensation expense recognized in the consolidated statement of operations pursuant to SFAS No. 123(R) is based on awards ultimately expected to vest, expense for
grants beginning upon adoption of SFAS No. 123(R) on January 1, 2006 is reduced for estimated forfeitures. The estimated forfeiture rate used in the calculation of share-based
compensation expense was 18.89% for the year ended December 31, 2007. The estimated forfeiture rates used in the calculation of share-based compensation expense ranged from 17.74% to 19.41% for
the year ended December 31, 2006. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ
from those estimates. Forfeitures are estimated based on historical experience.

A
summary of option activity for all Wave option plans through December 31, 2007 follows:

|                                                     |  | 2007      |   | 2006 |       | 2005
|---------------------------------------------------- |  | --------- | - | ---- | ----- | ----
|
|Balance at beginning of year                         |  | 4,825,928 |   | $    | 8.97  |     
|Granted                                              |  | 2,313,667 |   |      | 2.15  |     
|Forfeited                                            |  | (127,913  | ) |      | 2.31  |     
|Expired                                              |  | (91,889   | ) |      | 10.25 |     
|Exercised                                            |  | (3,315    | ) |      | 2.43  |     
|                                                     |  |           |   |      |       |     
|Balance at end of year                               |  | 6,916,478 |   |      | 6.80  |     
|                                                     |  |           |   |      |       |     
|Exercisable at end of year                           |  | 3,936,647 |   | $    | 10.33 |     
|                                                     |  |           |   |      |       |     
|Additional shares available for grant at end of year |  | 3,933,187 |   |      |       |     
|                                                     |  |           |   |      |       |     

The
weighted average grant date fair value of options granted during the years ended December 31, 2007, 2006 and 2005 was $1.59, $1.46 and $2.43, respectively.

The
weighted average remaining contractual term for options outstanding and options exercisable at December 31, 2007 were 6.3 and 4.2 years, respectively.

As
of December 31, 2007, unrecognized stock-based compensation related to stock options was approximately $2,199,000. At December 31, 2007, the weighted average period this
cost is expected to be expensed is 2.4 years. The total fair value of shares that vested during the years ended December 31, 2007, 2006 and 2005 was approximately $1,561,000, $1,788,000
and $757,000, respectively.

As
of December 31, 2007, the intrinsic value of outstanding, vested and currently exercisable share options was $-0-.

F-21

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(8) Share-based Compensation (Continued)

The
following table summarizes information about stock options outstanding under the Wave stock options plans as of December 31, 2007:

|                 |  | Options Outstanding |  | Options Exercisable
|---------------- |  | ------------------- |  | -------------------
|
|$0  $2.00       |  | 2,318,800           |  | 9.0                
|$2.01  $3.00    |  | 1,589,187           |  | 7.8                
|$3.01  $4.25    |  | 524,264             |  | 4.9                
|$4.26  $5.50    |  | 610,673             |  | 5.5                
|$5.51  $10.00   |  | 358,004             |  | 4.4                
|$10.01  $11.25  |  | 502,292             |  | 0.4                
|$11.26  $22.50  |  | 533,174             |  | 2.6                
|$22.51  $112.50 |  | 480,084.            |  | 2.1                
|                 |  |                     |  |                    
|                 |  | 6,916,478           |  | 6.3                

Pro forma Information under SFAS No.123

The following table shows the pro forma effect on net loss and net loss per share if Wave had applied the fair value recognition provisions of SFAS 123 to
stock-based employee awards.

For the year ended
December 31, 2005Net loss to common shareholdersas reported

$
(17,562,462
)Fair value compensation cost under SFAS 123


(2,103,508
)Net loss to common shareholderspro forma


(19,665,970
)Loss per common share (basic/diluted)as reported


(0.63
)Loss per common share (basic/diluted)pro forma

$
(0.72
)


The
following values for the indicated variables were used to value options granted during the year ended December 31, 2005.

Expected Term (in years)

5 YearsRisk-free Rate

4.23
%Expected Volatility

104
%Dividend Yield

0
%


1999 Wavexpress Stock Incentive Plan

In April 2000, the board of directors of Wavexpress authorized the establishment of a stock option plan. The total number of shares of Wavexpress' Class A
Common Stock subject to the Plan is 2,500,000. Options terminate upon the earlier of the date of expiration of the option or upon termination of the employment relationship between Wavexpress and the
optionee for any reason other than death, disability or retirement.

F-22

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(8) Share-based Compensation (Continued)

Employees
are entitled to exercise their options on dates determined by Wavexpress' 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.

Stock
option activity during 2007, 2006 and 2005 is as follows:

|                                                     |  | 2007      |   | 2006 |      | 2005
|---------------------------------------------------- |  | --------- | - | ---- | ---- | ----
|
|Balance at Beginning of year                         |  | 637,163   |   | $    | 1.23 |     
|Granted                                              |  |          |   |      |     |     
|Canceled                                             |  | (12,500   | ) |      | 1.20 |     
|                                                     |  |           |   |      |      |     
|Balance at end of year                               |  | 624,663   |   |      | 1.23 |     
|                                                     |  |           |   |      |      |     
|Exercisable at end of year                           |  | 624,663   |   |      | 1.23 |     
|                                                     |  |           |   |      |      |     
|Additional shares available for grant at end of year |  | 1,847,560 |   |      |      |     
|                                                     |  |           |   |      |      |     

No
options were granted under the Wavexpress stock option plan during the years ended December 31, 2007, 2006 and 2005.

The
following table summarizes information about Wavexpress' stock options outstanding at December 31, 2007:

|              |  | Options Outstanding |  | Options Exercisable
|------------- |  | ------------------- |  | -------------------
|
|$1.20         |  | 616,466             |  | 4.1                
|$3.00  $4.50 |  | 8,197               |  | 2.6                
|              |  |                     |  |                    
|$1.20  $4.50 |  | 624,663             |  | 4.1                
|              |  |                     |  |                    

Employee Stock Purchase Plan

In November 2004, the Board of Directors adopted the Wave Systems Corp. 2004 Employee Stock Purchase Plan (the "Purchase Plan") pursuant to which a total of
1,000,000 shares of Wave's Common Stock may be sold to eligible employees at a 15% discount from the market value of the shares. The Purchase Plan was ratified by a shareholder vote at Wave's 2005
annual shareholder meeting on May 23, 2005. Under the terms of the Purchase Plan, employees may elect to have withheld, up to 15% of their base earnings to purchase these shares during each
offering period, up to a maximum of $25,000 in market value of Wave Common Stock. Offering periods commence on May 1st and December 1st and are for a period of six months.
The purchase price under the Purchase Plan is 85% of the lesser of the market price on the beginning or the ending of the offering period. Approximately 34%, 37% and 49% of eligible employees
participated in the Purchase Plan for the years ended

F-23

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(8) Share-based Compensation (Continued)

December 31,
2007, 2006 and 2005, respectively. For the year ended December 31, 2007 employees purchased 219,166 shares of Wave Class A Common Stock at an average share price of
$1.46 per share, for an aggregate of $320,377 in proceeds to Wave. For the year ended December 31, 2006 employees purchased 144,975 shares of Wave Class A Common Stock at an average
share price of $1.99 per share, for an aggregate of $287,834 in proceeds to Wave. For the year ended December 31, 2005 employees purchased 164,047 shares of Wave Class A Common Stock at
an average share price of $2.16 per share, for an aggregate of $354,047 in proceeds to Wave.

(9) Warrants

In connection with an agreement that Wave entered into with an outside software development consultant, on August 7, 2007, Wave issued a warrant to
purchase up to 5,000 shares of Class A Common Stock at a price of $1.99 per share. The fair market value of these warrants was approximately $7,300 and was recorded as consultant expense in
2007. This warrant is exercisable on August 7, 2008 and expires August 7, 2012.

On
May 24, 2007, Wave issued to a placement agent warrants to purchase up to 365,853 shares of Class A Common Stock, in connection with a securities purchase agreement,
pursuant to which Wave sold and issued 7,317,073 shares of Class A Common Stock, par value $.01 per share for an aggregate purchase price of $15,000,000. The warrants are exercisable at an
exercise price of $2.58 per share and expire on May 24, 2009. If exercised in full, the warrants granted in connection with this financing may generate up to an additional $943,901, at the
exercise price. The warrants may also be exercised on a cashless basis. All of the warrants granted in connection with the May 24, 2007 securities purchase agreement remain outstanding as of
December 31, 2007.

On
October 30, 2006, Wave issued to a placement agent warrants to purchase up to 175,861 shares of Class A Common Stock, in connection with a securities purchase agreement,
pursuant to which Wave sold and issued 3,517,230 shares of Class A Common Stock, par value $.01 per share for an aggregate purchase price of $9,602,038. The warrants were exercisable at an
exercise price of $2.73 per share and expired unexercised on November 30, 2007.

On
August 4, 2006, Wave issued to a placement agent warrants to purchase up to 116,837 shares of Class A Common Stock, in connection with a securities purchase agreement,
pursuant to which Wave sold and issued 2,336,752 shares of Class A Common Stock, par value $.01 per share for an aggregate purchase price of $4,790,342. The warrants were exercisable at an
exercise price of $2.05 per share and expired unexercised on September 3, 2007.

On
May 3, 2006, Wave issued to a placement agent warrants to purchase up to 100,625 shares of Class A Common Stock, in connection with a securities purchase agreement,
pursuant to which Wave sold and issued 2,012,500 shares of Class A Common Stock, par value $.01 per share for an aggregate purchase price of $4,830,000. The warrants were exercisable at an
exercise price of $2.40 per share and expired unexercised on June 3, 2007.

On
February 15, 2006, Wave granted warrants to purchase up to 516,956 shares of Class A common stock at an exercise price of $2.16 in connection with a financing competed
as of that date (See Footnote 7Common Stock). The warrants were exercisable for a period of six months following the date of issuance. On May 8, 2006, warrants to purchase 162,037
shares were exercised on May 8, 2006, at the exercise price of $2.16 per share. Wave received net proceeds of $336,000, after deducting

F-24

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(9) Warrants (Continued)

placement
agent fees of $14,000, for the exercise of these warrants. The remaining warrants to purchase 354,919 shares expired unexercised on August 16, 2006.

On
December 5, 2005, Wave granted warrants to purchase up to 364,583 shares of Class A Common Stock, in connection with a securities purchase agreement. The warrants were
exercisable at an exercise price of $2.40 per share and were set to expire on June 5, 2006. Any shares of Class A Common Stock issuable upon exercise of these warrants were to be
drawn-down off of a shelf registration statement. On May 8, 2006, an investor exercised a warrant issued by Wave to that investor in connection with Wave's December 5, 2005
financing. The warrant was exercised in full for 114,583 shares of Wave Class A Common Stock, at its exercise price of $2.40 per share. Wave received $264,000 from the exercise of this warrant
after subtracting the 4% placement agent fee. The remaining warrants expired unexercised on June 5, 2006.

On
July 30, 2004, Wave granted warrants to purchase up to 1,470,588 shares of Class A Common Stock, in connection with a securities purchase agreement that Wave entered
into with certain purchasers as of that date. The warrants granted in this transaction were made up of two different series, Series A and Series B. The Series A warrants were
exercisable for up to 1,176,471 shares of Class A Common Stock at an exercise price of $3.45 per share. The Series A warrants were exercisable from January 30, 2005, until
August 1, 2005. The Series B warrants were exercisable for up to 294,118 shares of Class A Common Stock at an exercise price of $3.90 per share. The Series B warrants were
exercisable from July 30, 2005, until January 30, 2006. Any shares of Class A Common Stock issuable upon exercise of the Series A warrants and Series B warrants were
also to be drawn-down off of a shelf registration statement. The Series A and Series B warrants issued in this transaction carried a subsequent equity clause that required
Wave to adjust the initial exercise price, pro-rata, for any subsequent equity sales that were made at a lower price than the initial exercise price. As a result several sales of common
stock subsequent to the July 30, 2004 securities purchase agreement, the exercise prices of the Series A and Series B warrants were adjusted to $3.39 and $3.60, respectively, in
accordance with the formula pursuant to the warrant agreements. On August 1, 2005 a Series A Warrant holder exercised a portion of the Series A Warrant for a total of 666,667
shares at an exercise price of $3.39 per share, for aggregate gross proceeds of $2,260,000, less placement agent fees of $90,400, for net proceeds of $2,169,600. The remaining warrants for 509,804
expired on August 1, 2005. All of the Series B Warrants granted in connection with the July 30, 2004 securities purchase agreement expired unexercised on January 30, 2006.

In
connection with an agreement that Wave entered into with an outside software development consultant, on January 2, 2004, Wave issued warrants to purchase 10,000 shares of
Class A Common Stock at a price of $3.00 per share, pursuant to an individual compensation plan with the consultant.
Also, in connection with the same agreement, on April 30, 2004 an additional warrant was issued to the consultant to purchase 11,667 shares of Class A Common Stock at an exercise price
of $3.00 per share. The fair market value of these warrants was approximately $81,000 and was recorded as consultant expense in 2004. No additional warrants are required to be granted pursuant to the
individual compensation plan for the sales representative. These warrants are currently exercisable and expire January 2, 2009 through April 30, 2009.

On
November 18, 2003, Wave granted warrants to purchase 310,436 shares of Class A Common Stock at an exercise price of $7.86 per share in connection with a private
placement to a group of accredited investors. The warrants had a three year term. In addition, in connection with the

F-25

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(9) Warrants (Continued)

transaction,
Wave granted additional warrants to purchase 53,865 shares of Class A Common Stock as commissions to placement agents in connection with the private placement. The warrants granted
to the placement agents are also exercisable at a price of $7.86 per share and had a 3 year life as well. All of the warrants granted in connection with the November 18, 2003 private
placement expired unexercised in November 2006.

On
April 30, 2003, Wave granted the Series H Warrants to purchase shares of Class A Common Stock, with an initial exercise price of $3.39 per share and a five
(5) year life. Initially, the Series H Warrants were exercisable for a total of 1,202,852 shares of Class A Common Stock on the trading day following the date of Wave's 2003
annual meeting of stockholders. During September 2003 the terms of the Series H Purchase Agreement and other documents governing the Series H Stock and the Series H Warrants were
modified. As of December 31, 2003, 877,438 shares of Class A Common Stock were issued in connection with the exercise of Series H Warrants for net proceeds of $2,565,167.
Series H Warrants to acquire 21,930 shares of Class A Common Stock remain outstanding as of December 31, 2007.

In
connection with an agreement that Wave entered into with an outside sales representative, Wave issued warrants to purchase 14,788 shares of Class A Common Stock at prices
ranging from $2.85 to $4.35 per share, pursuant to an individual compensation plan with the sales representative. The fair market value of these warrants was approximately $146,000 and was recorded as
consultant expense in 2003. No additional warrants are required to be granted pursuant to the individual compensation plan for the sales representative. These warrants are currently exercisable and
expire January 1, 2013 through April 30, 2013.

In
connection with a software development agreement that Wave entered into with Archon Technologies, Inc. ("Archon"), Wave issued to Archon a warrant to purchase 16,667 shares of
Wave Class A Common Stock at $10.44 per share. The warrant became exercisable on November 9, 2002, and expired unexercised on November 9, 2007.

A
summary of warrants outstanding at December 31, 2007, follows:

|              |  | Warrants Outstanding |  | Warrants Exercisable
|------------- |  | -------------------- |  | --------------------
|
|$1.99  $2.84 |  | 370,853              |  | 1.4                 
|$2.85  $4.39 |  | 58,385               |  | 1.9                 
|              |  |                      |  |                     
|              |  | 429,238              |  | 1.5                 
|              |  |                      |  |                     

(10) Wavexpress

In April 1999, Wave joined with Sarnoff Corporation to form Wavexpress. Wavexpress develops secure broadband media distribution software products, infrastructure
and content services. On October 15, 1999, Wave and Sarnoff signed a Joint Venture Agreement, which formally established Wavexpress. Under this agreement, Sarnoff and its affiliates received a
40% equity stake in Wavexpress. Wave received a 53% equity interest, and its affiliates, who purchased founders stock in April 1999 for

F-26

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(10) Wavexpress (Continued)

a
nominal amount, owned the remaining 7% of the outstanding capital stock. The affiliates of Wave include Peter Sprague, the former Chairman of Wave and Steven Sprague, the Chief Executive Officer of
Wave, certain members of the Board of Directors of Wave and certain Wave employees.

Wave
has funded Wavexpress through a series of convertible notes, some with attached warrants. The notes bear interest at the rate of 2% to 3% above the Prime Rate of Chase Manhattan
Bank. Generally, the notes are convertible into shares of common stock of Wavexpress at varying prices per share. Through December 31, 2007, Wave has funded Wavexpress with approximately
$42,496,000 in cash, plus approximately $21,276,000 in accrued interest. Such amounts include approximately $9,500,000 that automatically converted into 1,826,571 additional shares of Wavexpress at an
average conversion price of $5.20 per share. These amounts are eliminated in consolidation.

As
of December 31, 2007, Wave owned 69% of Wavexpress, while Sarnoff owned 25.6%. None of the minority shareholders have provided, or are obligated to provide, funding to
Wavexpress. Accordingly, the financial statements of Wavexpress have been included in the consolidated financial statements of Wave for all periods presented herein. In addition, Wave has not recorded
a minority interest in Wavexpress in the consolidated financial statements and therefore has reflected 100% of Wavexpress' balance sheet and operating results in its consolidated financial statements.
Wavexpress has incurred net operating losses of $2.9 million, $2.4 million and $2.2 million, for the years ended December 31, 2007, 2006 and 2005, respectively.

(11) Commitments and Contingencies

Leases

Summarized below is a listing of properties leased by Wave pursuant to non-cancelable operating leases. Wave's principal research and development
activities are conducted at the Princeton and Cupertino facilities. Wave's broadband media distribution services, offered through Wavexpress, are conducted primarily at the New York facility.

Location

Annual
Lease Cost

Lease
Expiration DateLee, MA

$
148,683

Aug. 2010Princeton, NJ


168,058

Dec. 2009Cupertino, CA


499,365

Aug. 2013Orvault, France


67,260

Sep. 2010New York, NY(1)


120,000

Oct. 2008Total

$
1,003,366


---

F-27

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(11) Commitments and Contingencies (Continued)

Future minimum lease payments under non-cancelable operating leases (with initial or remaining lease terms in excess of one year) as of
December 31, 2007 are as follows:

2008

$
983,3662009


912,4122010


604,1292011


522,246Thereafter


624,227Total minimum lease payments

$
3,646,380


Rent
expense for the years ended December 31, 2007, 2006, 2005 amounted to approximately $916,000, $790,000 and $957,000, respectively.

There
were no capital lease obligations as of December 31, 2007 and 2006.

Purported Class Actions

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

The
purported class action has been filed by alleged purchasers of Wave's Class A Common Stock during the purported class period July 31, 2003 through February 2,
2004. The complaint claimed that Wave and the named individuals violated Section 10(b) of the Securities Exchange Act of 1934 (the "1934 Act"), Rule 10(b)-5 promulgated there
under and Section 20(a) of the 1934 Act by publicly disseminating materially false and misleading statements, relating to Wave's agreements with Intel and IBM. The complaint did not specify the
amount of alleged damages plaintiffs sought to recover.

In
January 2006, the Court granted in part and denied in part defendants' motion to dismiss. The court dismissed two but let stand seven alleged misrepresentations or omissions. This was
not a finding of fault or liability, it was a decision not entirely to dismiss plaintiffs' pleading.

Without
admitting liability, the defendants recently reached a mediated settlement in principle of all claims asserted by the plaintiffs. On January 10, 2007, the Court issued an
Order and Final Judgment approving the settlement and dismissing the action with prejudice. Wave's insurer has paid the plaintiffs a total of $1,750,000 in exchange for the dismissal with prejudice
and release of the claims against all defendants.

(12) Income Taxes

The Company did not provide for any income tax expense or (benefit) for the years ending December 31, 2007, 2006 and 2005.

F-28

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(12) Income Taxes (Continued)

The
following table summarizes the significant differences between the United States federal statutory tax rate and the Company's effective tax rate for financial statement reporting
purposes:

2007

2006

2005Statutory tax rate

34
%
34
%
34
%Stock-based compensation on ISO's

(3
)
(3
)
(0
)Gain on warrant liability

(0
)
(0
)
(1
)Change in valuation allowance

(31
)
(31
)
(33
)Total


%

%

%


The
tax effects of temporary differences that give rise to the deferred tax asset at December 31, 2007 and 2006 are as follows:

2007

2006Deferred tax assets:Net operating and capital loss carryforwards

$
105,680,000

$
97,946,000Accrued expenses


425,000


323,000Intangibles


446,000


471,000Reserves


945,000


917,000Depreciation


467,000


552,000Total gross deferred tax assets


107,963,000


100,209,000Less valuation allowance


(107,963,000
)

(100,209,000
)Net deferred tax asset

$


$



The
valuation allowance increased by approximately $7.8 million and $6.3 million, during the years ended December 31, 2007 and 2006, respectively.

Management
has concluded that it is more likely than not that Wave will not have sufficient taxable income of an appropriate character within the carryback and carryforward periods
permitted by current law to allow for the utilization of the deferred tax assets and, therefore, a valuation allowance has been established against the deferred tax assets of $107,963,000 as of
December 31, 2007. Subsequently reported tax benefits relating to the valuation allowance for deferred tax assets as of December 31, 2007 will be allocated as follows: $107,194,000 to
continuing operations and $768,000 to additional paid-in capital for amounts attributable to exercise of employee stock options.

Wave
has federal and state net operating loss carryforwards approximately $278.4 million, which expire beginning in 2008 through 2027. Wave also has capital loss carryforwards for
tax return purposes of approximately $8.6 million, which expire beginning in 2008 through 2010. Pursuant to Section 382 of the Internal Revenue Code, the annual utilization of Wave's net
operating and capital loss carryforwards may be substantially limited if a cumulative change in ownership of more than 50% occurs within any three-year period. Wave has not determined
whether there have been such cumulative changes in ownership or the impact on the utilization of the loss carryforwards if such changes have occurred. However, in considering Section 382 of the
Internal Revenue Code, Wave believes that it is likely that such a change in ownership has occurred thus raising the likelihood that such net operating and capital loss carryforwards are subject to
annual limitations.

F-29

---



WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(12) Income Taxes (Continued)

The
Company adopted the provisions of FIN 48 effective January 1, 2007. The adoption did not result in an adjustment to retained earnings due to the Company's full valuation
allowance against its net deferred tax asset.

The
following table summarizes the activity related to the Company's gross unrecognized tax benefits:

Gross
Unrecognized
Tax BenefitsBalance at January 1, 2007

$
7,123,302Increases related to current year tax positions


2,304,885Balance at December 31, 2007

$
9,428,187


The
unrecognized tax benefits, if recognized, would not affect the Company's effective tax rate because the Company has recorded a full valuation allowance against its net deferred tax
assets.

The
Company's policy is to recognize interest and penalties related to unrecognized tax benefits as a component of income tax expense. The Company files United States Federal and state
income tax returns. In general, the statute of limitations with respect to the Company's United States Federal income taxes has expired for years prior to 2004, and the relevant state statutes vary.
However, preceding years remain open to examination by United States Federal and state taxing authorities to the extent of future utilization of net operating losses and capital losses generated in
each preceding year. The Company does not anticipate that the total unrecognized tax benefits will change significantly prior to December 31, 2008. As described above, utilization of the
Company's loss carryforwards may be limited pursuant to Section 382 of the Internal Revenue Code. Any limitation may result in expiration of a portion of the net operating and capital loss
carryforwards before utilization. Until a study is completed and any limitation known, no amounts are being presented as an uncertain tax position under FIN 48.

(13) Defined Contribution Plan

Wave 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 Wave become eligible immediately on employment. Wave has the option to make discretionary matching contributions; no contributions were made in 2007, 2006 or 2005.

(14) Disclosures about the Fair Value of Financial Instruments

Cash and Cash Equivalents, Prepaid Expenses and Other Receivables, Accounts Payable and Accrued Expenses

The carrying amounts of these instruments approximate fair value because of their short maturities.

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

F-30

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(14) Disclosures about the Fair Value of Financial Instruments (Continued)

uncertainties
and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

(15) Segment Reporting

Wave's products include the Wave EMBASSY® digital security products and services ("EMBASSY®") and Wavexpress broadband media distribution
products and services. These products and services constitute Wave's reportable segments under Statement of Financial Accounting Statement No. 131Disclosures about Segments of an
Enterprise and Related Information. Net losses for reportable segments exclude interest income, unrealized gains on decrease in value of warrant liability, gain on sales of marketable securities and
other income. These items are not reported by segment since they are excluded from the measurement of segment performance reviewed by Wave's management.

F-31

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(15) Segment Reporting (Continued)

The
following sets forth reportable segment data:

|                                       |                                                               | For the years ended December 31, |  
|-------------------------------------- | ------------------------------------------------------------- | -------------------------------- | -
|
|Operating Revenues:                    |                                                               |                                  |  
|                                       | EMBASSY® digital security products and services               |                                  | $
|                                       | Wavexpress broadband media distribution products and services |                                  |  
|                                       |                                                               |                                  |  
|                                       | Total Operating Revenues                                      |                                  |  
|Net Loss:                              |                                                               |                                  |  
|                                       | EMBASSY® digital security products and services               |                                  |  
|                                       | Wavexpress broadband media distribution products and services |                                  |  
|                                       |                                                               |                                  |  
|                                       | Total Segments Net Loss                                       |                                  |  
|                                       | Interest Income                                               |                                  |  
|                                       | Unrealized gain on decrease in value of warrant liability     |                                  |  
|                                       | Gain on sale of marketable securities                         |                                  |  
|                                       | Other Income                                                  |                                  |  
|                                       |                                                               |                                  |  
|                                       | Net Loss                                                      |                                  | $
|                                       |                                                               |                                  |  
|Depreciation and Amortization Expense: |                                                               |                                  |  
|                                       | EMBASSY® digital security products and services               |                                  |  
|                                       | Wavexpress broadband media distribution products and services |                                  |  
|                                       |                                                               |                                  |  
|                                       | Total Depreciation and Amortization Expense                   |                                  | $
|                                       |                                                               |                                  |  
|Capital Expenditures:                  |                                                               |                                  |  
|                                       | EMBASSY® digital security products and services               |                                  |  
|                                       | Wavexpress broadband media distribution products and services |                                  |  
|                                       |                                                               |                                  |  
|                                       | Total Capital Expenditures                                    |                                  | $
|                                       |                                                               |                                  |  

|        |                                                               | As of
|------- | ------------------------------------------------------------- | -----
|
|Assets: |                                                               |      
|        | EMBASSY® digital security products and services               |      
|        | Wavexpress broadband media distribution products and services |      
|        |                                                               |      
|        | Total Assets                                                  |      
|        |                                                               |      

F-32

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(15) Segment Reporting (Continued)

The
following table details Wave's sales by geographic area for the years ended December 31, 2007, 2006 and 2005. Geographic area is based on the location of where the products
were shipped or services rendered.

|                                                              |            | United States
of America |           | Europe    |   | Asia    |         | Total |        
|------------------------------------------------------------- | ---------- | ------------------------ | --------- | --------- | - | ------- | ------- | ----- | -------
|2007                                                          |            |                          |           |           |   |         |         |       |        
|EMBASSY® digital security products and services               |            | $                        | 5,947,111 |           | $ | 225,444 |         | $     | 134,405
|Wavexpress broadband media distribution products and services |            |                          |          |           |   |        |         |       |       
|                                                              |            |                          |           |           |   |         |         |       |        
|                                                              | Total      |                          |           | 5,947,111 |   |         | 225,444 |       |        
|                                                              | % of Total |                          |           | 94        | % |         | 4       | %     |        
|                                                              | 2006       |                          |           |           |   |         |         |       |        
|EMBASSY® digital security products and services               |            |                          | 2,102,959 |           |   | 792,744 |         |       | 190,934
|Wavexpress broadband media distribution products and services |            |                          | 29,744    |           |   |        |         |       |       
|                                                              |            |                          |           |           |   |         |         |       |        
|                                                              | Total      |                          |           | 2,132,703 |   |         | 792,744 |       |        
|                                                              | % of Total |                          |           | 68        | % |         | 26      | %     |        
|                                                              | 2005       |                          |           |           |   |         |         |       |        
|EMBASSY® digital security products and services               |            |                          | 352,761   |           |   | 467,537 |         |       | 156,510
|Wavexpress broadband media distribution products and services |            |                          | 41,657    |           |   |        |         |       |       
|                                                              |            |                          |           |           |   |         |         |       |        
|                                                              | Total      |                          | $         | 394,418   |   | $       | 467,537 |       | $      
|                                                              | % of Total |                          |           | 39        | % |         | 46      | %     |        

Substantially all long-lived assets of Wave Systems Corp. are located within the United States of America.

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

|                    |       |          |  | 2007 |           | 2006      |   | 2005      |          
|------------------- | ----- | -------- |  | ---- | --------- | --------- | - | --------- | ---------
|
|
|Dell, Inc.          |       | EMBASSY® |  | $    | 4,483,053 |           | $ | 1,094,041 |          
|ST Microelectronics |       | EMBASSY® |  |      |          |           |   | 774,695   |          
|Broadcom            |       | EMBASSY® |  |      | 682,129   |           |   | 335,899   |          
|US Government       |       | EMBASSY® |  |      |          |           |   | 319,877   |          
|Winbond             |       | EMBASSY® |  |      |          |           |   |          |          
|Intel               |       | EMBASSY® |  |      |          |           |   |          |          
|                    |       |          |  |      |           |           |   |           |          
|                    | Total |          |  |      | $         | 5,165,182 |   | $         | 2,524,512
|% of Total Revenue  |       |          |  |      | 81        | %         |   | 81        | %        

F-33

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WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Continued)

(16) Selected Quarterly Financial Data (unaudited)

|                          |  | Quarter-ended |           
|------------------------- |  | ------------- | ----------
|
|Revenues                  |  | $             | 1,875,319 
|Gross Profit              |  |               | 1,643,411 
|Loss from Operations      |  |               | (5,357,009
|Net loss                  |  |               | (5,287,557
|Net loss per Common Share |  | $             | (0.11     

|
|

|                          |  | Quarter-ended |           
|------------------------- |  | ------------- | ----------
|
|Revenues                  |  | $             | 866,542   
|Gross Profit              |  |               | 656,775   
|Loss from Operations      |  |               | (4,851,786
|Net loss                  |  |               | (4,766,989
|Net loss per Common Share |  | $             | (0.12     

(17) Subsequent Event

On February 29, 2008, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 3,173,500 shares of Class A Common
Stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $3,490,850. These shares were priced at $1.10 per share. Securities Research Associates, Inc. ("SRA")
entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a fee equal to 6.0% of the gross proceeds of
this offering. Wave also agreed to issue warrants to the subscribers to purchase up to 952,050 shares of Class A common stock at an exercise price of $1.15 per share. These warrants expire in
February 2013. Additionally, Wave agreed to issue a warrant to SRA to purchase up to 190,410 shares of Class A common stock at an exercise price of $1.33 per share. This warrant expires on
February 28, 2010. Wave realized net proceeds of approximately $3,221,000 after deducting the placement agent fees of $209,451 and additional legal and other fees associated with the issuance
of these securities which totaled approximately $60,000. The shares sold on February 29, 2008 were offered and issued pursuant to a shelf registration statement on Form S-3
which was filed by Wave on March 20, 2007 and declared effective by the Commission on April 27, 2007.

F-34

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