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



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FORM
20-F


|  |                                                                                                   
|- | --------------------------------------------------------------------------------------------------
|o | REGISTRATION
  STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF
  1934
|  |                                                                                                   
|  | OR                                                                                                
|  |                                                                                                   
|x | ANNUAL
  REPORT PURSUANT TO SECTION 13 OF 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934            
|  |                                                                                                   
|  | For
  the fiscal year ended December 31, 2005                                                     
|  |                                                                                                   
|  | OR                                                                                                
|  |                                                                                                   
|o | TRANSITION
  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934        
|  |                                                                                                   
|  | For
  the transition period from __________ to __________                                         
|  |                                                                                                   
|o | SHELL
  COMPANY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
  OF 1934   
|  |                                                                                                   
|  | Date
  of event requiring this shell company report _____________                                 
|  |                                                                                                   
|  | Commission File No.
  1-8201                                                                      

ALADDIN KNOWLEDGE SYSTEMS LTD.(Exact name of Registrant as specified in its charter and
translation of Registrants name into English)

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Israel(Jurisdiction of incorporation or organization)15 Beit Oved Street, Tel Aviv 61110, Israel(Address of principal executive offices)




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Securities
registered or to be registered pursuant to Section 12(b) of the Act:NoneSecurities registered or to be registered pursuant to Section 12(g) of the Act:Ordinary Shares, nominal value 0.01 New Israeli Shekel per share(Title of Class)Securities for which there is a reporting obligation pursuant to Section 15(d)
of the Act:None(Title of Class)


Indicate the
number of outstanding shares of each of the issuers classes of capital or
common stock as of December 31, 2005:

14,485,063
Ordinary Shares

Indicate by check
mark if the registrant is a well-known seasoned issuer, as defined in Rule 405
of the Securities Act.

o  Yesx  No

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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.

x  Yes       
        o  No

If this report is an annual or transition report,
indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

o  Yesx  No

Indicate by check mark whether the registrant is a
large accelerated filer, an accelerated filer, or a non-accelerated filer. See
definition of accelerated filer and large accelerated filer in Rule 12b-2
of the Exchange Act.

o  Large Accelerated Filer     x 
 Accelerated Filer     o  Non-Accelerated Filer

Indicate by check mark which financial statements the
registrant has elected to follow.

Item 17  o          Item
18  x

If this is an annual report, indicate by check mark
whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).

o  Yesx  No

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CAUTIONARY
NOTE FOR FORWARD-LOOKING STATEMENTS

Except
for the historical information contained herein, the statements contained in
this annual report are forward-looking statements, within the meaning of the
Private Securities Litigation Report Act of 1995 with respect to our business,
financial condition and results of operations. Actual results could differ
materially from those anticipated in these forward-looking statements as a
result of various factors, including, but not limited to, all the risks
discussed or identified in this annual report and our other public filings,
such as general economic and market conditions, changes in regulations and
taxes and changes in competition and pricing environments.

We
desire to take advantage of the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995 and we are including this cautionary
statement in connection with this safe harbor legislation. This document and
any other written or oral statements made by us or on our behalf may include
forward-looking statements, which reflect our current views with respect to
future events and financial performance. We urge you to consider that
statements which use the terms believe, do not believe, expect, plan,
intend, estimate, anticipate, and similar expressions are intended to
identify forward-looking statements. These statements reflect our current views
with respect to future events and are based on assumptions and are subject to
risks and uncertainties. Except as required by applicable law, including the
securities laws of the United States, we do not intend to update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise.

We
have based these forward-looking statements on our current expectations and
projections about future events. These statements include but are not limited
to:

|  |                                                                                                                                                                                 
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | expectations as to the development of our products
  and technology, and the timing of enhancements to our products and new
  product launches;                                 
|  |                                                                                                                                                                                 
| | statements as to expected increases in sales,
  results of operations and certain expenses, including research and
  development and sales and marketing expenses;              
|  |                                                                                                                                                                                 
| | expectations as to the market opportunities for our
  products, as well as our ability to take advantage of those opportunities;                                                
|  |                                                                                                                                                                                 
| | expectations as to growth of the software DRM and
  enterprise security markets;                                                                                                
|  |                                                                                                                                                                                 
| | expectations as to the development of our marketing
  and sales relationships;                                                                                                  
|  |                                                                                                                                                                                 
| | statements as to the expected outcome of legal and
  patent proceedings in which we are involved;                                                                               
|  |                                                                                                                                                                                 
| | estimates of the impact of changes in currency
  exchange rates on our results of operations;                                                                                   
|  |                                                                                                                                                                                 
| | expectations as to the adequacy of our inventory of
  critical components;                                                                                                      
|  |                                                                                                                                                                                 
| | expectations as to the adequacy of our manufacturing
  facilities; and                                                                                                          
|  |                                                                                                                                                                                 
| | statements as to our expected treatment under
  Israeli and U.S. federal tax legislation and the impact that Israeli tax and
  corporate legislation may have on our operations.

As
used in this annual report, the terms we, us, our, the Company and
Aladdin mean Aladdin Knowledge Systems Ltd. and its subsidiaries, unless
otherwise indicated.

We
have prepared our consolidated financial statements in United States dollars.
All references herein to dollars or $ are to United States dollars, and all
references to Shekels or NIS are to New Israeli Shekels.

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TABLE
OF CONTENTS

|            |  |                                                                                |  |    | 
|----------- |  | ------------------------------------------------------------------------------ |  | -- | 
|PART I.     |  |                                                                                |  | 1  | 
|Item
  1.   |  | Identity of Directors, Senior
  Management and Advisers                        |  | 1  | 
|Item
  2.   |  | Offer Statistics and Expected
  Timetable                                      |  | 1  | 
|Item
  3.   |  | Key Information                                                                |  | 1  | 
|Item
  4.   |  | Information on the Company                                                     |  | 11 | 
|Item
  5.   |  | Operating and Financial Review and
  Prospects                                 |  | 23 | 
|Item
  6.   |  | Directors, Senior Management and Employees                                     |  | 34 | 
|Item
  7.   |  | Major Shareholders and Related Party
  Transactions                            |  | 39 | 
|Item
  8.   |  | Financial Information                                                          |  | 41 | 
|Item
  9.   |  | The Offer and Listing                                                          |  | 42 | 
|Item
  10.  |  | Additional Information                                                         |  | 44 | 
|Item
  11.  |  | Quantitative and Qualitative
  Disclosures About Market Risk                   |  | 54 | 
|Item
  12.  |  | Descriptions of Securities Other
  than Equity Securities                      |  | 56 | 
|            |  |                                                                                |  |    | 
|PART II.    |  |                                                                                |  | 56 | 
|Item
  13.  |  | Defaults, Dividend Arrearages and
  Delinquencies                              |  | 56 | 
|Item
  14.  |  | Material Modifications to the Rights
  of Security Holders and Use of Proceeds |  | 56 | 
|Item
  15.  |  | Controls and Procedures                                                        |  | 56 | 
|Item
  16A. |  | Audit Committee Financial Expert                                               |  | 56 | 
|Item
  16B. |  | Code of Ethics                                                                 |  | 56 | 
|Item
  16C. |  | Principal Accountant Fees and
  Services                                       |  | 56 | 
|Item
  16D. |  | Exemptions for the Listing Standards
  for Audit Committees                    |  | 57 | 
|Item
  16E. |  | Purchase of Equity Securities by the
  Issuer and Affiliated Purchasers        |  | 57 | 
|            |  |                                                                                |  |    | 
|PART III.   |  |                                                                                |  | 57 | 
|Item
  17.  |  | Financial Statements                                                           |  | 57 | 
|Item
  18.  |  | Financial Statements                                                           |  | 57 | 
|Item
  19.  |  | Exhibits                                                                       |  | 57 | 

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PART I.

|                                                                  | 
|----------------------------------------------------------------- | 
|Item 1.  Identity of Directors, Senior
  Management and Advisers.

Not
Applicable.

|                                                   | 
|-------------------------------------------------- | 
|Item 2. Offer Statistics and Expected
  Timetable.

Not
Applicable.

|                         | 
|------------------------ | 
|Item 3. Key Information.

A. SELECTED FINANCIAL DATA.

We
derived the selected consolidated statement of operations data set forth below
for the years ended December 31, 2003, 2004 and 2005, and the selected
consolidated balance sheet data as of December 31, 2004 and 2005, from our
audited consolidated financial statements, included elsewhere in this annual
report. We derived the consolidated statement of operations data for the years
ended December 31, 2001 and 2002 and the selected consolidated balance sheet
data as of December 31, 2001, 2002 and 2003 from audited consolidated financial
statements that are not included in this annual report. Please see Note 2 to
our Consolidated Financial Statements for a discussion of our significant
accounting policies. Our consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United
States (GAAP).

The
following selected financial data should be read in conjunction with the
section of this annual report entitled Operating and Financial Review and
Prospects and our consolidated financial statements and notes thereto included
elsewhere in this annual report. Historical results are not necessarily
indicative of any results to be expected in any future period. Please see notes
2 and 16 of the notes to our audited consolidated financial statements for an
explanation regarding the computation of basic and diluted net earnings (loss)
per ordinary share.

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|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|------------------------------------------------------------------------------------ |  | ---------------------------------------------- | ------- | ---- | - | ------ | - | ---- | ------ | ---- | - | ------ | - | - | ------ | 
|                                                                                     |  | Year ended December 31,                        |        
|                                                                                     |  | 2001                                           |         | 2002 |   | 2003   |   | 2004 |        | 2005 |  
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |  
|                                                                                     |  | (In thousands, except earnings per share data) |        
|Consolidated statement of operations data:                                           |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Revenues:                                                                            |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Software security                                                                    |  | $                                              | 38,421  |      | $ | 40,093 |   | $    | 43,521 |      | $ | 50,650 |   | $ | 56,578 | 
|Enterprise security                                                                  |  |                                                | 8,192   |      |   | 9,427  |   |      | 11,204 |      |   | 18,471 |   |   | 25,195 | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Total revenues                                                                       |  |                                                | 46,613  |      |   | 49,520 |   |      | 54,725 |      |   | 69,121 |   |   | 81,773 | 
|Cost of revenues:                                                                    |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Software security                                                                    |  |                                                | 7,753   |      |   | 8,405  |   |      | 7,995  |      |   | 9,541  |   |   | 9,870  | 
|Enterprise security                                                                  |  |                                                | 1,567   |      |   | 1,833  |   |      | 1,804  |      |   | 4,240  |   |   | 7,101  | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Total cost of revenues                                                               |  |                                                | 9,320   |      |   | 10,238 |   |      | 9,799  |      |   | 13,781 |   |   | 16,971 | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Gross profit                                                                         |  |                                                | 37,293  |      |   | 39,282 |   |      | 44,926 |      |   | 55,340 |   |   | 64,802 | 
|Operating expenses:                                                                  |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Research and development                                                             |  |                                                | 11,043  |      |   | 12,245 |   |      | 12,759 |      |   | 12,028 |   |   | 12,131 | 
|Selling and marketing                                                                |  |                                                | 22,474  |      |   | 21,990 |   |      | 22,012 |      |   | 24,677 |   |   | 26,952 | 
|General and administrative                                                           |  |                                                | 8,877   |      |   | 7,247  |   |      | 7,745  |      |   | 8,805  |   |   | 11,169 | 
|Impairment of intangible assets                                                      |  |                                                | 5,211   |      |   |       |   |      |       |      |   |       |   |   |       | 
|One-time lawsuit charge                                                              |  |                                                |        |      |   |       |   |      |       |      |   |       |   |   | 2,000  | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Total operating expenses                                                             |  |                                                | 47,605  |      |   | 41,482 |   |      | 42,516 |      |   | 45,510 |   |   | 52,252 | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Operating income (loss)                                                              |  |                                                | (10,312 | )    |   | (2,200 | ) |      | 2,410  |      |   | 9,830  |   |   | 12,550 | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Financial income (expenses), net                                                     |  |                                                | (410    | )    |   | 491    |   |      | 480    |      |   | 53     |   |   | 1,038  | 
|Other income (expenses), net                                                         |  |                                                | (3,372  | )    |   | (932   | ) |      | (5     | )    |   | (138   | ) |   | 14     | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Income (loss) before taxes                                                           |  |                                                | (14,094 | )    |   | (2,641 | ) |      | 2,885  |      |   | 9,745  |   |   | 13,602 | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Taxes on income                                                                      |  |                                                | (347    | )    |   | 2,738  |   |      | 49     |      |   | 957    |   |   | 1,246  | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Income (loss) before equity in losses of an affiliate                                |  |                                                | (13,747 | )    |   | (5,379 | ) |      | 2,836  |      |   | 8,788  |   |   | 12,356 | 
|Equity in losses of an affiliate                                                     |  |                                                | (1,168  | )    |   | (1,257 | ) |      | (100   | )    |   |       |   |   |       | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Net income (loss)                                                                    |  | $                                              | (14,915 | )    | $ | (6,636 | ) | $    | 2,736  |      | $ | 8,788  |   | $ | 12,356 | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Net earnings (loss) per share:                                                       |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Basic                                                                                |  | $                                              | (1.32   | )    | $ | (0.59  | ) | $    | 0.24   |      | $ | 0.74   |   | $ | 0.89   | 
|Diluted                                                                              |  |                                                | (1.32   | )    | $ | (0.59  | ) | $    | 0.23   |      | $ | 0.68   |   | $ | 0.85   | 
|                                                                                     |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Weighted average number of shares used in computing net earnings
  (loss) per share: |  |                                                |         |      |   |        |   |      |        |      |   |        |   |   |        | 
|Basic                                                                                |  |                                                | 11,275  |      |   | 11,253 |   |      | 11,287 |      |   | 11,940 |   |   | 13,899 | 
|Diluted                                                                              |  |                                                | 11,275  |      |   | 11,253 |   |      | 11,950 |      |   | 13,000 |   |   | 14,580 | 

2

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|                                                   |  |                |        |      |   |        |  |      |        |      |   |        |  |   |         | 
|-------------------------------------------------- |  | -------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------- | 
|                                                   |  | December 31,   |       
|                                                   |  | 2001           |        | 2002 |   | 2003   |  | 2004 |        | 2005 |  
|                                                   |  |                |        |      |   |        |  |      |        |      |  
|                                                   |  | (In thousands) |       
|Consolidated balance sheet data:                   |  |                |        |      |   |        |  |      |        |      |   |        |  |   |         | 
|Cash, cash equivalents and marketable
  securities |  | $              | 13,438 |      | $ | 15,095 |  | $    | 19,516 |      | $ | 25,911 |  | $ | 77,241  | 
|Working capital                                    |  |                | 24,649 |      |   | 22,664 |  |      | 26,625 |      |   | 34,111 |  |   | 84,974  | 
|Total assets                                       |  |                | 53,395 |      |   | 48,539 |  |      | 55,468 |      |   | 70,894 |  |   | 125,878 | 
|Total liabilities                                  |  |                | 10,766 |      |   | 12,212 |  |      | 14,512 |      |   | 17,457 |  |   | 21,141  | 
|Share capital and additional paid-in
  capital     |  |                | 36,184 |      |   | 36,184 |  |      | 36,184 |      |   | 39,735 |  |   | 78,998  | 
|Shareholders equity                               |  |                | 42,629 |      |   | 36,327 |  |      | 40,956 |      |   | 53,437 |  |   | 104,737 | 

B.
CAPITALIZATION AND INDEBTEDNESS

Not
applicable.

C. REASONS FOR
THE OFFER AND USE OF PROCEEDS

Not
applicable.

D. RISK FACTORS

RISKS RELATED TO OUR BUSINESS

We face intense competition in each of the
segments in which we operate and our results of operations will be adversely
affected if we fail to compete successfully.

We
face intense competition in each of the segments in which we operate. In the
hardware-based software licensing authentication token, or SLAT, market, our
software digital rights management, or DRM, solutions compete with products
sold by SafeNet Inc., which acquired Rainbow Technologies Inc., and in the
software-based software protection market, one of our competitors is
Macrovision Corporation. One of our competitors in the authentication market is
RSA Security Inc.., which holds a dominant position in the one-time passwords,
or OTP market, and SafeNet, which manufactures a USB-based authentication
product. We also compete with smart card manufacturers. Our primary competitor
in the content security market for gateway solutions is Trend Micro Inc., which
holds a dominant market position. In addition, the overall content security
market is characterized by a number of large companies, such as Symantec
Corporation, McAfee, Inc. and Trend Micro, which in 2005 together accounted for
over 60% of global revenues in this market as well as a large number of small
companies. While the primary focus of these companies is desktop or network
solutions and not the gateway solution offered by eSafe, we would face
significant additional competition if these companies decided to pursue the
gateway market more aggressively. In addition, some vendors of firewalls have
decided to extend their offerings to gateway security and are starting to
compete with our eSafe product. Many of our current and potential competitors
have significantly greater name recognition, larger customer bases and greater
financial, technical, manufacturing, marketing and other resources than we do.
Our results of operations will be adversely affected if our competitors succeed
in marketing products with superior performance or at lower prices than our
products.

We derive a substantial portion of our
revenues from our software DRM segment. Our results of operations would be
materially adversely affected if sales of our software DRM products were to
decline.

We
currently derive a substantial portion of our revenues from our software DRM
segment, consisting entirely of sales of our HASP line of products. We expect
to continue to derive a substantial portion of our revenues from this segment
for the foreseeable future. Since our software DRM products target the software
industry, sales reflect trends in the software business cycle. In recent years,
software vendors have experienced deteriorating economic conditions as
corporate customers have reduced capital expenditures. Demand for our software
DRM products is driven, to some extent, by end-user demand for software
applications. If software vendors experience

3

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deteriorating
sales due to an economic downturn, demand for our software DRM products could
decline. This would have a material adverse effect on our results of
operations.

We rely on sole source suppliers for a number
of key components of our products and if we need to seek alternate suppliers
our results of operations could be adversely affected.

We
purchase certain key components for each of our hardware-based products from
sole source suppliers. In particular, we obtain from sole source suppliers the
application specific integrated circuits and microcontrollers included in our
HASP products, and the microcontroller and the smart card, including its
operating system, for our eToken products. In addition, we license the
anti-spam and web filtering functions incorporated in eSafe and receive
services related to these functions from a third party pursuant to a license agreement
that expires on December 31, 2006 and automatically renews for unlimited
successive one-year periods subject to either partys request to terminate at
the end of the initial term or any extension. We would need to seek an
alternative licensor and service provider for these functions if this third
party ceases to provide these services or decides not to extend the license. If
any of our suppliers become unable to or refuses to manufacture these
components or if we experience delays in delivery of, or shortages in, these
components, which has happened from time to time, it could interrupt and delay
the manufacture of our products. In the event of a disruption in supply, we
cannot assure you that our inventory would be sufficient to enable us to continue
manufacturing during the time that it would take to modify the design and
integrate substitute components. Any such disruption could adversely affect our
results of operations.

Changing preferences and new industry
initiatives may render our products obsolete.

We
cannot assure you that software publishers will continue to prefer to protect
their software through hardware-based solutions over software-based solutions.
A change in preference towards software-based solutions could materially adversely
affect the sales of our HASP HL token-based products, which currently represent
close to 70% of our total revenues. In addition, even if our software-based
HASP SL solution was adopted by software publishers, this would have a material
adverse affect on our results of operations.

An
emerging trend in the software industry is providing Software as a Service
(SaaS). This concept is based on hosting the software application in a server
and providing its functionality as a centralized service, combined with a
strong underlying business model and connectivity to the customers
back-office. SaaS does not sell software the traditional way, by burning
software onto CDs for sale. Consequently, SaaS does not require piracy
protection and licensing the way traditional software products do. It requires
instead strong protection of the server against intruders, and higher level of
authentication of the user. These protections are not provided by our existing
software DRM solutions. We cannot guarantee that we will be able to modify
HASPHL to meet the needs of SaaS. If SaaS becomes a significant trend in the
software industry it may adversely affect our results of operations.

Furthermore,
a number of participants in the computer industry have commenced an initiative
to implement trusted computing functions which may replicate some of the
features of our software DRM products. In particular, Microsoft Corporation has
announced the development of its Next-Generation Secure Computing Base architecture
which, among other things, is intended to contain software DRM functionality.
In addition, a consortium of companies in the computer industry, including
Advanced Micro Devices, Inc., Hewlett-Packard Company, IBM Corporation, Intel
Corporation, Microsoft, Sony Corporation and Sun Microsystems, Inc. have formed
the Trusted Computing Group to implement trusted computing. The Trusted
Computing Groups principal goal is the development of an additional chip that
enhances security of computers.

Software
developers have started to add security features to new versions of their
software that are designed to limit intrusions by unauthorized users or viruses
and spyware via the Internet. Moreover, last year, Microsoft announced its
expected development of an anti-virus service geared towards consumers and that the upcoming new
version of Windows (Vista) will have many security features that are designed
to minimize penetration of malicious code. Stronger security in future
Microsoft platforms may significantly minimize the vulnerabilities through
which virus and vandal penetration is possible. This, in turn, might lower the
need to implement anti-virus solutions such as eSafe. As the incorporation of
such features in future versions of operating systems and software make these
systems less susceptible to outside penetration, our eSafe product may be
rendered obsolete or unmarketable.

4

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We may not be successful in keeping pace with
the rapid technological changes that characterize our industry.

The
markets for our products are characterized by rapid technological change,
evolving industry standards and changes in end-user requirements. Hackers
constantly improve their methods of stealing end-user technology, software and
identities, and new viruses and unwanted content are constantly emerging. In
addition, new software operating systems, network systems or industry standards
could emerge. Emerging trends in these systems and standards currently include
applications distributed over the Internet and the use of a web browser to
access client-server systems. Our existing products might be incompatible with
some or all of such standards. Therefore, our future success depends upon our
ability to enhance our existing products and to develop and introduce products
that address these new requirements. We cannot assure you that we will be able
to develop new or enhanced products in a timely manner. Our failure to keep
pace with these changes could adversely affect our results of operations.

A key element of our growth strategy is
increasing sales of our eToken product line.

A
key element of our growth strategy is increasing sales of our eToken product
line worldwide, which currently represent a small portion of our revenues. Much
of this growth will depend on widespread market acceptance of USB-based
authentication devices over competing authentication technologies, such as OTP
and smart cards. We cannot assure you that the market will continue to accept
our eToken products as superior to these existing technologies. If this market
does not grow as projected, or if our marketing and selling efforts do not
succeed, and eToken adoption rates are lower than we project, we may not
achieve our growth targets, and our results of operations may be adversely
affected.

We may not be able to prevent others from
successfully claiming that we infringed their proprietary rights.

The
software protection and Internet security industries are characterized by the
existence of a large number of patents and frequent litigation based on
allegations of patent infringement and the violation of other intellectual
property rights. Many of our competitors have extensive patent portfolios with
broad claims. In addition, individuals and organizations that may not compete
with us directly may also have patents with broad claims. As the number of
competitors in the market grows and the functionality of our products
increases, the possibility of an intellectual property claim against us
increases. In addition, because patent applications can take many years to be
published, there may be a patent application now pending of which we are
unaware, which will cause us to be infringing when issued in the future. To
address any patent infringement or other intellectual property claims, we may
have to redesign our products to avoid infringement or enter into royalty or
licensing agreements on disadvantageous commercial terms. We may also be unable
to successfully redesign our products or obtain a necessary license. These outcomes
could result in us having to stop the sale, or result in increased costs, of
some of our products, and could harm our reputation.

In
the past, we have been subject to claims that resulted in us paying amounts in
settlements or obtaining licenses to use intellectual property rights as a
result of third-party claims against us. In May 2004, we were named as
defendant in a U.S. patent infringement complaint alleging that certain of our
products infringed a now-expired patent. In April 2005, we reached a settlement
with respect to this claim pursuant to which we made a one-time payment of $2
million to the plaintiffs in exchange for a full release of all claims. In
addition, from time to time, we have received notices from third parties
offering to license to us certain aspects of their technology. Any infringement
or other intellectual property claims, with or without merit, which are brought
against us could be time consuming and expensive to litigate or settle and
could divert managements attention from our business.

We may not be able to protect our
intellectual property rights.

Our
success and ability to compete greatly depends on our proprietary technology.
We rely on a combination of patents, copyrights, trademarks, trade secrets,
know-how and confidentiality clauses in our agreements to protect our
intellectual property. We cannot assure you that we will successfully protect
our technology because:

|  |                                                                                                                                                                                                                   
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | to license
  our products, we rely on shrink wrap licenses that are not signed by the
  customer and, therefore, we may not be able to enforce our proprietary rights
  under the laws of certain jurisdictions;

5

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|  |                                                                                                                                                                                                                                                                        
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | some foreign
  countries may not protect our proprietary rights as fully as the laws of the
  United States;                                                                                                                                                           
|  |                                                                                                                                                                                                                                                                        
| | if a
  competitor were to infringe our proprietary rights, enforcing our rights may
  be time-consuming and costly, diverting both our managements attention and
  our resources, and could result in challenges to the validity of our rights;                       
|  |                                                                                                                                                                                                                                                                        
| | measures
  such as entering into non-disclosure agreements afford only limited
  protection because monitoring unauthorized uses of trade secrets and
  confidential information is difficult and we may not have adequate remedies
  for any breach of our agreements;
|  |                                                                                                                                                                                                                                                                        
| | unauthorized
  parties may attempt to copy aspects of our products and develop similar
  software or to obtain and use information that we regard as proprietary; and                                                                                                  
|  |                                                                                                                                                                                                                                                                        
| | our
  competitors may be able to independently develop products that are
  substantially equivalent or superior to our products or design around our
  intellectual property rights.                                                                                   

We
also have a number of patent applications pending. We cannot be certain that
patents will be issued with respect to any of our pending or future patent
applications or, that if patents are issued, the patents will be issued in a
form that is advantageous to us. In the event that these or any other patent
applications are published but not issued, they will become publicly available
and proprietary information will become available to others. In addition, we do
not know whether any issued patents will be upheld as valid, proven enforceable
against alleged infringers or that they will prevent the development of
competitive products.

Sales of products that contain encryption technologies are
  subject to export and other restrictions, and our failure to comply with applicable
  government regulations could subject us to sanctions and adversely affect our
  ability to sell our products.

Our
eToken and HASP product lines contain encryption technologies which require a
permit from the Israeli government for their development and export. We have
obtained a general permit for our HASP HL product which does not require
renewals, and we have a special permit to export eToken which requires annual
renewal. Any failure to renew this permit on a timely basis or at all would
prevent us from exporting eToken for sale outside of Israel. The sale of eToken
in some countries may require special approval by the Israeli government, per
sale, and there can be no guarantee that the Israeli government will provide
such approval. In addition, we may need to apply for additional permits in the
future to export products currently under development that include encryption
technologies. There can be no guarantee that the Israeli government will grant
such permits. Furthermore, the laws or regulations governing the export of
encryption technologies may change and we may be required to comply with more
stringent requirements. We also conduct some of our research and development
activities in Germany and may be subject to regulations regarding export of
technologies.

In
addition, the import and sale of products containing encryption technologies
are subject to various regulations in the countries in which we sell our
products. Our independent distributors are contractually responsible for
compliance with any governmental regulations in countries in which they sell
our products, and we rely upon them to fully comply with these regulations. We
are responsible for compliance with governmental regulations in countries or
regions in which we make direct sales of our products. We have not conducted a
survey of applicable governmental regulations in the jurisdictions in which we
make direct sales, and we have not conducted an audit of our independent
distributors to determine their compliance with applicable governmental
regulations. Therefore, our subsidiaries and independent distributors may be
noncompliant with the laws and regulations of these jurisdictions and could
face fines, penalties or other sanctions, including limitations on their
ability to sell our products.

We rely on independent distributors for a
portion of our revenues, and we intend to enter into additional distribution
arrangements in the future, which may increase this reliance.

We
market and sell our software DRM products through independent distributors in
all of the countries in which we do not have subsidiaries, and we market and
sell our eSafe and eToken product lines generally through indirect sales
channels, which include independent distributors. In 2005, 42% of our revenues
were generated from

6

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sales to
independent distributors. Under our agreements with independent distributors,
each distributor is granted a non-exclusive right in each particular country or
region to market our products for an initial term of one year, subject to
meeting minimum sales targets. Our success in generating sales in countries or
regions where we have engaged independent distributors depends in part on their
efforts. We cannot assure you that our distributors will devote sufficient
resources to market and support our products effectively or that they will meet
minimum sales targets. In the future, we intend to sign additional distribution
agreements, which may make us more dependent on our distributors. In addition,
if we decide to terminate a relationship with an independent distributor, this
could disrupt our relationships with customers served by the terminated
distributor.

Our strategy of establishing original
equipment manufacturer, or OEM, relationships for sales of our enterprise
security product lines may not succeed and may result in difficulties in
distinguishing our brand.

A
key element of our growth strategy in our enterprise security segment is to
establish OEM relationships with large technology vendors with the aim of
encouraging them to incorporate our eToken and eSafe product lines into their
products. To date, we have entered into two such relationships with respect to
eToken. We believe that the success of our enterprise security segment is
dependent, in part, on the establishment of additional OEM relationships in the
future. The establishment of OEM relationships is a time-consuming, expensive
and unpredictable process, and often involves complex issues relating to the
adaptation of our products. Furthermore, OEM relationships may not contain any
minimum purchase requirements and there can be no guarantee that any
relationship that we establish will result in significant sales. In addition,
because OEMs purchase products to be incorporated into their own products, we
may lose the ability to brand our products effectively and interact directly
with end-users of our products. This may make it easier for OEMs to replace our
products with those of our competitors or with products that the OEM partner
has developed on its own. Should this occur, we could experience pressure to
reduce our prices, or risk losing these relationships. Either of these would
adversely affect our results of operations.

Fluctuations in currency exchange rates may
have a significant impact on our reported results of operations.

Although
our reporting currency is the U.S. dollar, a significant portion of our
revenues and expenses are denominated in currencies other than the U.S. dollar
including, in particular, the Euro. In periods when the U.S. dollar strengthens
against these other currencies our reported results of operations may be
adversely affected. In addition, fluctuations in currencies may result in
valuation adjustments in our assets and liabilities which could affect our
reported results of operations.

Maintenance and upgrades of our products may
disrupt our customers operations and may provide them with an opportunity to
switch to competing products.

We
need to upgrade and improve our products periodically. When we upgrade or
deploy new versions of our products, we require the cooperation of our existing
customers. If our periodic upgrades cause complications or disruptions, we may
lose revenues and we may also be the subject of negative publicity that may
harm our reputation. In addition, the upgrade process creates a decision point
for our customers to consider and possibly switch to alternative products.

Our products may contain undetected errors
which could disrupt our customers critical business functions.

Some
of our products could contain errors or defects. Our eSafe product resides on
the customers gateway, a critical juncture that allows access to the Internet.
A failure of our eSafe product can temporarily cause the disruption of critical
business functions, including the ability to access the Internet or communicate
by electronic mail during an outage. Such a failure of eSafe or our other
products could cause significant financial losses and disruption to our
customers. Our end-user license agreements, distribution agreements and
reseller agreements contain limitation of liabilities clauses which may not be
enforceable for indirect or incidental damages arising from the use of our
products. This could expose us to greater financial risk and adversely affect
our results of operations. Any defects in our existing or new products could
result in a loss of revenues and claims against us, a diversion of our
resources, damage to our reputation or increased service and other costs.

7

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Some of our products may cause conflicts and
failures in our customers systems.

Some
models of our HASP products operate through the parallel port of a users
computer. We believe that over half of our installed base of HASP keys use this
technology. The design of the parallel port-based HASP keys employs
technologies that may not function properly when used in conjunction with
certain printers or other devices that share the parallel port. Also, future
changes in design by printer and device manufacturers could result in HASP keys
that were installed and worked properly in the past no longer operating
effectively. While we do not warrant the full compatibility of the parallel
port-based HASP keys with all parallel port devices, our reputation could be
harmed by widespread failures of these products.

Our software DRM products may leave customers
vulnerable to piracy, which could seriously harm our business.

Our
software DRM products do not provide absolute protection against piracy. We,
together with our customers, continuously face challenges from computer
hackers, who attempt to neutralize the protection our products provide in order
to enable unlicensed copying of our customers software. In recent years, we
have faced increasing attacks by hackers who have developed methods to
circumvent the protection provided by our software DRM products. Such methods
are often publicized over the Internet, making them readily available to those
who wish to make unlicensed copies of our customers software. We are
constantly in the process of developing and releasing solutions designed to
respond to our customers complaints and handle hacking problems. Furthermore,
we have recently received notifications from some of our customers informing us
that hackers had succeeded in breaking the protection provided by our HASP
products. We cannot guarantee that hackers will not continue to develop methods
to contravene the protection provided by our products. Failure to provide
effective software protection solutions could seriously harm our business.

Our content security products may fail to
protect our customers networks from virus attacks and vandalism, which could
seriously harm our business.

Our
content security products do not provide absolute protection against viruses
and vandalism. We, together with our customers, continuously face challenges
from hackers, who attempt to neutralize the protection our products provide in
order to penetrate and harm our customers networks. Failure to provide
effective content security solutions could seriously harm our business.

Acquisitions could result in dilution,
operating difficulties and other adverse consequences.

During
the last ten years, we have completed a number of acquisitions of businesses
and product lines. The process of integrating any acquired business into our
own business and operations is challenging and may create unforeseen operating
difficulties and expenditures. The areas in which we may face difficulties
include:

|  |                                                                                                                                                                                                                                  
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | diversion of
  our managements time after consummation of the acquisition from the ongoing
  development of our businesses, and the release of future products and
  services;                                                  
|  |                                                                                                                                                                                                                                  
| | a decline in
  employee morale and retention issues, both at our company and at the acquired
  company, resulting from changes in compensation, reporting relationships,
  future prospects or the direction of the business; and
|  |                                                                                                                                                                                                                                  
| | integration
  of new product lines, accounting, management and internal controls.                                                                                                                                                

Future
acquisitions could also result in potentially dilutive issuances of equity
securities, the incurrence of debt, contingent liabilities or impairment
related to goodwill and other intangible assets, any of which could harm our
business. In addition, future acquisitions could require us to obtain
additional equity or debt financing, which may not be available on favorable
terms or at all and may be dilutive.

8

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We must comply with new European governmental
regulations setting environmental standards.

Our activities
in Europe require that we comply with European Union Directives with respect to
product quality assurance standards and environmental standards. Directive 2002/95/ec
of the European Parliament on the Restriction of the Use of Certain Hazardous
Substances in Electrical and Electronic Equipment, known as the RoHS Directive,
will take effect on July 1, 2006 and requires that certain of our products be
modified to meet this regulation. Some of our distributors and customers are
already requiring us to comply with these new rules so as not to be left with
noncompliant inventory when the RoHS Directive takes effect. If we fail to
achieve compliance, we may be restricted from selling our products in the
European Union and this could adversely affect our results of operations.
European Directive 2002/96/EC on waste, electrical and electronic equipment,
know as the WEEE Directive, makes manufacturers of electrical and electronic
equipment financially responsible for specified collection, recycling,
treatment and disposal of past and future covered products. The WEEE Directive
became effective on August 13, 2005. We may incur financial responsibility for
the collection, recycling, treatment or disposal of products covered under the
WEEE Directive. Because the EU member states have not fully implemented the
WEEE Directive, the nature and extent of the costs to comply and fees or
penalties associated with noncompliance are unknown at this time. Costs to
comply with the WEEE Directive and similar future legislation, if applicable,
may also include legal and regulatory costs and insurance costs. We may also be
required to take reserves for costs associated with compliance with these
regulations.

RISKS RELATED TO OUR ORDINARY SHARES

The market prices of our ordinary shares have
been and may continue to be volatile.

Our
ordinary shares have been subject to and will continue to be subject to a great
deal of volatility. For example, during 2005, the price of our ordinary shares
on The Nasdaq National Market fluctuated between $15.95 and $25.40 per share.
We cannot predict the fluctuations in the market price of our ordinary shares.
The broader market for technology stocks and, in particular, those of companies
based in Israel has also been subject to significant price fluctuations. These
broad market fluctuations may adversely affect the market price of our ordinary
shares, regardless of our actual operating performance. Such volatility in
relation to our ordinary shares may also affect our ability to raise additional
equity financing in the future.

Our Chairman and Chief Executive Officer,
Jacob (Yanki) Margalit, and our director, Dany Margalit, have significant
influence over matters requiring shareholder and board approval.

Our
Chairman and Chief Executive Officer, Jacob (Yanki) Margalit, and our director,
Dany Margalit, collectively own or control 18.1% of our outstanding ordinary
shares. Messrs. Margalit are brothers, and both sit on our board of directors
which comprises a total of five members. Accordingly, they have substantial
influence over the outcome of corporate actions requiring director or
shareholder approval, including the election of directors, any merger,
consolidation or sale of all or substantially all of our assets and any other
significant corporate transaction. These shareholders may also delay or prevent
a change of control of us, even if such a change of control would benefit our
other shareholders.

Our ordinary shares are traded on more than
one market and this may result in price variations and volatility.

Our
ordinary shares are traded on The Nasdaq National Market and the Tel Aviv Stock
Exchange. Trading in our ordinary shares on these markets is made in different
currencies (dollars on The Nasdaq National Market and New Israeli Shekels on
the Tel Aviv Stock Exchange) and at different times (due to different time
zones, trading days and public holidays in the United States and Israel). The
trading prices of our ordinary shares on these two markets may differ due to
these and other factors. In addition, due to the smaller size of the local
capital markets, we may receive more media coverage in Israel and Israeli
investors may react to this coverage more quickly than investors elsewhere. Any
decrease in the trading price of our ordinary shares on one of these markets
could cause a decrease in the trading price of our ordinary shares on the other
market.

9

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Our results of operations are inherently
difficult to project and we may fail to meet our guidance or analysts
projections, which may adversely affect our share price.

We
deliver our products promptly following the receipt of customer orders and,
therefore, we do not have a significant backlog. In addition, a large
proportion of our sales are concentrated at the end of each quarter. These
factors make it difficult to project our quarterly results of operations.
Commencing in the first quarter of 2004, and for each quarter thereafter, we
have released financial guidance to the public during the first month of each
quarter with respect to that quarter. Should our actual results of operations
fall short of our guidance or analysts estimates, the price of our ordinary shares
may decline.

RISKS RELATED TO OUR OPERATIONS IN ISRAEL

Security, political and economic instability
in Israel may harm our business.

Our
corporate headquarters, manufacturing facilities and principal research and
development facilities are located in Israel. Accordingly, security, political
and economic conditions in Israel may directly affect our business. Over the
past several decades, a number of armed conflicts have occurred between Israel
and its Arab neighbors. Any hostilities involving Israel or the interruption or
curtailment of trade between Israel and its present trading partners could
affect our operations. Since September 2000, there has been a marked increase
in violence, civil unrest and hostility, including armed clashes between the
State of Israel and the Palestinian Authority and other groups in the West Bank
and Gaza Strip, and acts of terror have been committed inside Israel and
against Israeli targets in the West Bank and Gaza. The execution of Israels
plan of unilateral disengagement from the Gaza Strip and some parts of the West
Bank and Hamas gaining majority of the Palestinian Parliament in the elections
held recently in the Palestinian Authority, may affect Israels security,
foreign relations and the stability of the region. Increased hostilities,
future armed conflicts, political developments in other states in the region,
or continued or increased terrorism could make it more difficult for us to
conduct our operations in Israel, which could increase our costs and adversely
affect our financial results. For example, as many of our male employees in
Israel are obligated to perform annual military reserve duty typically until
between 44 and 46 years of age and in some cases up to 54 years of age, any
major escalation in hostilities in the region could result in a portion of our
employees being required to perform military duty for an extended period of
time.

Israel
has recently experienced unionized general strikes in connection with economic
reforms being passed into legislation. Due to the fact that our products are
manufactured in Israel and, for the most part, sold to customers outside of
Israel, a prolonged general strike would affect our ability to deliver our
products to our non-Israeli customers. We cannot guarantee that a prolonged
general strike in Israel would not have a material adverse effect on our
business, results of operations and financial condition.

We receive tax benefits that may be reduced
or eliminated in the future.

Three
of our expansion programs in Israel have been granted approved enterprise
status. We are therefore eligible for tax benefits under the Israeli Law for
Encouragement of Capital Investments, 1959 and its amendment, effective in
April 2005. The availability of these tax benefits is subject to certain
requirements, including making specified investments in property and equipment,
and financing a percentage of investments with share capital. If we do not meet
these requirements in the future, the tax benefits may be cancelled and we
could be required to refund any tax benefits that we have already received,
plus interest and penalties thereon. We cannot assure you that the tax benefits
that our current approved enterprise programs receive will be continued in the
future at their current levels or at all. If these tax benefits were reduced or
eliminated, the amount of taxes that we pay would likely increase.

It may be difficult and costly to enforce a
U.S. judgment against us, our officers and directors in Israel or the United
States, or to assert U.S. securities laws claims in Israel or serve process on
our officers and directors and these experts.

We
are incorporated in Israel. The majority of our executive officers and
directors are not residents of the United States, and the majority of our
assets and the assets of these persons are located outside the United States.
Therefore, it may be difficult to:

10

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|  |                                                                                                                                                                                                                                                                                                                             
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | effect
  service of process within the United States on us or any of our executive
  officers or directors who are nonresidents of the United States;                                                                                                                                                                       
|  |                                                                                                                                                                                                                                                                                                                             
| | enforce
  court judgments obtained in the United States including those predicated upon
  the civil liability provisions of the United States federal securities laws,
  against us or against any of our executive officers or directors which are
  nonresidents of the United States, in the United States or Israel; and
|  |                                                                                                                                                                                                                                                                                                                             
| | bring an
  original action in an Israeli court against us or against any of our
  executive officers or directors to enforce liabilities based upon the United
  States federal securities laws.                                                                                                                            

The rights and responsibilities of our
shareholders are governed by Israeli law and differ in some respects from the
rights and responsibilities of shareholders under U.S. law.

We
are incorporated under Israeli law. The rights and responsibilities of holders
of our ordinary shares are governed by our articles of association and by
Israeli law. These rights and responsibilities differ in some respects from the
rights and responsibilities of shareholders in typical U.S. corporations. In
particular, a shareholder of an Israeli company has a duty to act in good faith
toward the company and other shareholders and to refrain from abusing his power
in the company, including, among other things, in voting at the general meeting
of shareholders on certain matters. Israeli law provides that these duties are
applicable in shareholder votes on, among other things, amendments to a
companys articles of association, increases in a companys authorized share
capital, mergers and interested party transactions requiring shareholder
approval. In addition, a shareholder who knows that it possesses the power to
determine the outcome of a shareholder vote or to appoint or prevent the
appointment of a director or executive officer in the company has a duty of
fairness toward the company. However, Israeli law does not define the substance
of this duty of fairness. Because Israeli corporate law has undergone extensive
revision in recent years, there is little case law available to assist in
understanding the implications of these provisions that govern shareholder
behavior.

Provisions of Israeli law may delay, prevent
or make difficult a merger with or an acquisition of us, which could prevent a
change of control and therefore depress the price of our shares.

Provisions
of Israeli corporate and tax law may have the effect of delaying, preventing or
making more difficult a merger with, or other acquisition of, us. This could
cause our ordinary shares to trade at prices below the price for which third
parties might be willing to pay to gain control of us. Third parties who are
otherwise willing to pay a premium over prevailing market prices to gain
control of us may be unable or unwilling to do so because of these provisions
of Israeli law. For additional information about some anti-takeover effects of
Israeli law, see Item 10.B. Articles of AssociationAnti-Takeover Provisions;
Mergers and Acquisitions under Israeli Law.

Item 4. Information on the Company.

A. HISTORY AND
DEVELOPMENT OF THE COMPANY

Our
legal and commercial name is Aladdin Knowledge Systems Ltd. We were
incorporated in Israel in 1985. Our principal executive offices are located at
15 Beit Oved Street, P.O. Box 11141, Tel Aviv, Israel 61110, and our telephone
number is 972-3-636-2222. Our Internet address is: http://www.Aladdin.com.
Information on our web site is not incorporated by reference in this annual
report.

Capital Expenditures

During
the past three years, our capital expenditures amounted to approximately $4.5
million. The focus of our capital expenditure program primarily included
investment in IT systems, equipment for research and development and testing
purposes as well as general computer software and hardware. We continue to make
capital investments of a similar nature in our Israeli facilities and also in
connection with our production activities.

11

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B. BUSINESS
OVERVIEW

We
are a global provider of security solutions that reduce software theft,
strongly authenticate network users and protect against unwanted Internet- and
e-mail-borne content, including spam and viruses. Our products are organized
into two segments: software digital rights management, or DRM, and enterprise
security. Our software DRM solutions allow software publishers to limit revenue
loss from software theft and piracy. Our enterprise security solutions enable
organizations to secure their information technology assets by controlling who
has access to their networks and applications (authentication) and what content
their users can utilize (content security).

Our
software DRM product line, HASP, offers a comprehensive solution for the
protection, licensing and distribution needs of software publishers. Our
enterprise security products consist of eToken and eSafe. eToken is a solution
based on smart card devices, which ensures that only legitimate users gain
access to networks and PCs. eSafe is a gateway-based solution that proactively
protects networks against viruses, worms, spam and other unwanted Internet- and
e-mail-borne content.

We
sell our products globally to a large number of customers. We market and sell
our software DRM products directly, as well as through a network of independent
distributors. We market and sell our enterprise security solutions through
indirect channels, which include distributors, value-added resellers and system
integrators, and more recently, through OEM relationships. Organizations that
have adopted our enterprise security solutions include Fortune 500 companies
and cover a broad range of industries such as financial services,
telecommunications, airline, manufacturing and technology.

Within
the software DRM market, we focus on the hardware-based software licensing
authentication token, or SLAT, market, which is the largest segment of the
software DRM market. According to IDC, a market research firm focused on the
information technology and telecommunications industries, we are the global leader in
the SLAT market since 2002,
with a 37.2% market
share in 2004 (the most recent
year for which IDC has provided such data to date). We have grown our
customer base through a history of innovation in the security market and have a
broad portfolio of intellectual property, including a number of patents and
patent applications pending.

We
have experienced significant growth since our founding in 1985. Over the last
three years, we have achieved growth that is above the industry average and we
have increased our profitability in each of the last twelve quarters. We
believe that our core strength in the software DRM business is complemented by
increasing growth in the enterprise security segment, which has grown from
19.0% of our total revenues in 2002 to 31.0% of our total revenues in 2005.

Industry Background

With
global software piracy, malicious code attacks and unauthorized network access
presenting ever-greater threats, the need for reliable digital security
solutions has never been greater. To combat increasing software piracy,
software publishers are seeking DRM solutions to protect their intellectual
property. Software DRM solutions reduce software piracy by using either
hardware- or software-based software protection solutions. To avoid malicious
code attacks and unauthorized network access, and to enhance enterprise
security, organizations are seeking authentication and content security
solutions. Authentication solutions positively identify users (internally as
well as from outside the enterprise) before granting access to critical
applications and resources. Content security solutions protect networks against
viruses, worms, spam and other Internet- and e-mail-borne unwanted content.

Software DRM overview

The
advancement of digital technologies makes it possible to produce an essentially
perfect copy of any digital asset with minimal effort. Piracy affects all forms
of digital content, such as music, movies, text and software. With the advent
of the personal computer, software piracy first became an issue in the 1980s.
Development of the Internet in the 1990s virtually eliminated the need for a
physical medium to perform illegal transfers of digital assets. According to a
May 2005 study by the Business Software Alliance and IDC, software developers
lost $33 billion of potential revenue in 2004 due to software piracy, and in
some countries more than 90% of all software in use is pirated. Software piracy
impacts software publishers by preventing them from realizing all of the
licensing revenue from the use of their software products. Software piracy can
occur in many forms, including end-users

12

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making
unauthorized copies and distributing them to friends or co-workers, retailers
selling illegal copies, computer dealers loading illegal copies onto their
customers hardware, commercial counterfeiters offering illegal copies for sale
and enterprises exceeding the number of users or scope of use authorized by
license agreements.

Software
DRM can be implemented either through a hardware device or a software solution.
The hardware device is a hardware key that connects either to the USB or
parallel port of a computer and unlocks software residing on that computer.
IDC refers to this market as the software licensing authentication token, or
SLAT, market and projects that this market will grow from $140 million in 2005
to $166 million in 2009. Software-based solutions allow software publishers to
control end-use without distributing a hardware device and may also include
licensing and distribution capabilities.

Software DRM market trends

We
believe that the following are key growth drivers of the software DRM market:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Growth of piracy on the Internet.Increasing
        broadband access combined with peer-to-peer (P2P) networks and Internet
        publishing tools, such as bulletin boards and weblogs, are facilitating
        a rise in software piracy which can be limited by adopting software DRM
        solutions.                                                                                                                                     
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |  | Increasing variety of software licensing
        models. License management is an increasing concern for software publishers.
        Software license models are evolving and software publishers now deliver
        their software in an increasing variety of schemes including by software
        rental, trialware or pay per use arrangements. These more flexible licensing
        options drive the need for new software DRM solutions.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |  | Electronic software distribution. Software
        distribution is at the early stages of moving away from the traditional
        shrink-wrapped box towards electronic software distribution, or ESD. As
        ESD gains popularity and transmission of software becomes easier, software
        will become more vulnerable to piracy, on a wider scale, increasing the
        need for anti-piracy technologies.                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |  | Adoption of DRM features by platform vendors.
        In recent years, Microsoft has been implementing an increasing number
        of DRM features into its operating systems. This development has led to
        DRM solutions becoming more widely accepted by software publishers.                                                                                                                                                            

Enterprise
security overview

Enterprise
security has become a critical element of enterprise networks due to the
growing need for organizations to increase connectivity to their networks,
enhance their online services, and open new opportunities for electronic
business. To combat network security breaches, corruption of software
environments, and legal exposure, organizations are primarily focused on
securing their networks by controlling who accesses their networks
(authentication) and what content users can utilize (content security).

Authentication
overview

Organizations
are rapidly increasing the exchange of electronic information both internally,
among their employees and departments, and externally, with their customers,
vendors, business partners, suppliers and others. Extending information access
both inside and outside an organization has become critical to operating
organizations effectively. Increased access to critical information, however,
can lead to a greater risk of exposing this information to unauthorized users.
Hackers, cyber-terrorists, identity thieves, disgruntled employees and even
competitors can intercept information. A number of security technologies have
emerged to help organizations positively identify users before granting access
to enterprise networks.

Authentication
solutions range from simple single-factor systems that rely only on something
the user knows, such as a password, to strong or two-factor systems that rely
on multiple factors such as something the user has such as a token, as well as
something the user knows (e.g., a password). Strong authentication systems
include, among others, OTP tokens, smart cards and USB tokens. OTP tokens allow
users to authenticate themselves to backend servers by manually entering a
randomly generated, one-time password. Smart cards are authentication cards
that connect to a personal computer through special readers. USB tokens are
devices that connect to any computer USB port and have embedded software to
automatically perform user authentication functions. According to IDC, USB
tokens represent a high level of security and user acceptance.

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Authentication
market trends

According
to IDC, the traditional OTP token market is projected to grow from $214 million
in 2005 to $245 million in 2009, representing a compound annual growth rate of
3.4%. The USB hardware authentication market is projected to grow from $58
million to $212 million during this same period, representing a compound annual
growth rate of 38.3%. We believe that the following are key growth drivers of
the authentication market:

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Increasing access to enterprise networks.
  The need for strong authentication is increasing, as the scope of access to
  enterprise networks expands. Enterprises are expanding access to their
  networks to mobile workers and telecommuters, as well as to customers and
  business partners. Enterprises are also allocating more resources to
  authentication solutions for internal access.                                                                                                                                                                                                                                                                                                                                                                
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | Realization of password management costs.
  While stand-alone passwords as an authentication method were once viewed as
  free, numerous studies have shown that the most common call to help desks
  and support centers relates to passwords, costing a company $10 or more per
  incident. We believe that enterprises are more willing to consider more
  robust authentication solutions in light of the inherent costs of password
  management.                                                                                                                                                                                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | Regulatory compliance. A growing number of
  guidelines and regulations, such as the Sarbanes-Oxley Act (SOX), HIPAA, the
  Federal Financial Institutions Examination Councils (FFIEC) Authentication
  Guidance, Basel II, and more, hold organizations responsible for the
  integrity of their business data and for the protection of personal
  information that has been entrusted to them. Enterprises worldwide are feeling
  increasing pressure to comply to these guidelines and many allocate a key
  portion of their IT security spending for this purpose. Enterprises are
  adopting strong authentication to enhance compliance by enabling secure user
  access and providing an attestable method for protecting internal data and
  networks.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | Increasing adoption of authentication solutions for consumer
  applications. As on-line services become more
  pervasive, financial institutions, e-commerce providers and Internet service
  providers are increasingly providing their customers with authentication
  solutions to ensure secure on-line transactions and prevent consumer fraud.                                                                                                                                                                                                                                                                                                                                                                                                               

Content security overview

Existing
enterprise network infrastructure is susceptible to security attacks, which
compromise and threaten the utility of Internet usage and electronic messaging.
Enterprises are constantly exposed to viruses and spam spawned by access to
unauthorized Internet content and content contained in electronic messages.

In
addition, unmanaged, non-business use of company computing and network
resources, including Internet access, can result in increased risk and costs to
the employer, including lost employee productivity, increased network bandwidth
consumption, increased network security breaches and potential legal liability.

The
evolution of computing, organizational growth, content type and electronic
communication has resulted in increasing challenges for todays content
security solutions. Enterprises often have some form of information technology,
or IT, security; however, most installed solutions cannot adapt to the
creativity and volume of continuing threats and increasing regulatory
requirements. Organizations demand solutions that can operate within heterogeneous
environments, are able to scale to meet increasing content volume demands, that
lower management costs and enable safe electronic communication.

Content
security solutions enable policy-based management of Internet traffic and
electronic messaging and include virus protection, e-mail protection, web
filtering and other malicious content blocking (e.g., spyware, adware). There
are two principal approaches to intercepting malicious content: reactive and
proactive. The reactive approach involves the identification of malicious
content that has already invaded a network, and the subsequent updating of a
database consisting of a signature in order to block identical content in the
future. The shortcoming of this approach is that malicious content must first
have attacked and damaged a network before it can be identified and blocked in
the future. A proactive approach involves training the system to identify
behaviors that characterize malicious content, and eliminating content that
meets these criteria even before any network is damaged.

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Organizations
implement content security in three different layers: on the individual
desktops, on the network servers and on the perimeter Internet gateways.
Gateway solutions are complementary to the desktop and network server
solutions. Many enterprises look for different solution providers for different
layers to improve security. However, the advantage of a gateway solution over
other approaches is the ability to enforce a single comprehensive security
solution managed from a central location and enforce company-wide policies.
Managing network security from one central location is much more efficient than
trying to manage it from the desktop or network servers.

Content security market trends

The
content security market is projected to grow from $4.5 billion in 2004 to $10.5
billion in 2009, according to IDC. Sub-segments of content security include:

|  |                                                                                                                                                                                                                                                          
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Messaging
  security, which is used to monitor, filter and block messages from different
  messaging applications, is projected to grow from $665 million in 2004 to
  $2.6 billion in 2009, representing a compound annual growth rate of 31.3%;
  and  
|  |                                                                                                                                                                                                                                                          
| | Web
  filtering, which is used to screen and exclude web pages which are deemed
  objectionable or not business related, is projected to grow from $433 million
  in 2004 to $929 million in 2009, representing a compound annual growth rate
  of 16.5%.

We
believe that the following are key growth drivers of the content security
market:

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Higher frequency of worms and viruses.
  Attacks on consumers and corporate users have become easier with the
  proliferation of broadband access. According to Viruslist.com, a website
  focusing on Internet security, the number of new threats continues to grow at
  the rate of several hundred every day.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | Escalation of spyware. Organizations are
  becoming increasingly impacted by spyware, which steals critical information
  and user identities. IDC ranks spyware as the fourth-greatest threat to
  network security, well ahead of spam and even cyber-terrorism.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | Continuation of spam proliferation.
  According to a February 2006, Ferris Research report, spammers send an
  average of 15 billion spam email messages per day. This represents 60% out of
  a total of 25 billion email messages sent per day.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | Information and identity theft. The
  widespread use of the Internet for e-commerce and e-business has resulted in
  rapid growth in the number of information and identity theft cases. This, in
  turn, is causing a steadily growing awareness of the need for stronger
  information security. According to Gartner, 73 million adults who use the
  Internet received a phishing email between May 2004 and May 2005, and 2.4
  million online shoppers lost money as a direct result of phishing. Phishing
  is the act of sending an email to a user falsely claiming to be from an
  established, legitimate enterprise, in an attempt to lure them into spoofed
  sites often of those known brands. On those sites, users are mislead into
  surrendering private information that will be used for fraud and identity
  theft, or infected with spying Trojans, password stealers and other malicious
  code.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | Increasing regulation. Regulations such as
  the Gramm-Leach-Bailey Act, the Health Insurance Portability and Accountability
  Act and the Sarbanes-Oxley Act, each requires enhanced protection of
  sensitive personal and corporate data, have forced organizations to take
  additional measures to protect their networks.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

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Our Solutions

Software
DRM

Our
software DRM solutions allow publishers to manage how their software is
utilized while limiting software piracy and unauthorized use. We believe that
our software DRM solutions have the following benefits:

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------
| | Comprehensiveness and flexibility. We
  provide comprehensive and flexible alternatives for software publishers to
  license their software. Our customers can combine hardware-based,
  software-based and network-based software licensing. Utilizing our Protect
  OnceDeliver Many architecture, software publishers can prepare their
  software for distribution and implement differing licensing models for
  different markets.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
| | Security. Our advanced algorithms and
  anti-debugging features provide enhanced security to our customers. The high
  level of security is achieved through features such as:                                                                                                                                                                                                                                                             
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                            | an advanced
  encryption engine that employs state-of-the-art algorithms based on 128 bit
  Advanced Encryption Standard (AES) technology;
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                            | a
  hardware-based real-time clock, enabling time-based licensing and security; and                                                       
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                            | remote
  software updating using digitally signed secure files.                                                                           
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
|  | We believe
  that no competing product offers the combination of such features and the
  associated level of security.                                                                                                                                                                                                                                                                                                                     
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
| | Ease of use.Software publishers can protect their products without any special
programming by applying our proprietary software wrapping technology. For
end-users, installation of protected software is a simple and transparent
plug-and-play process.                                                                                                                                                                                  
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | Reliability.We believe our hardware keys are reliable even while operating in diverse
environments. Our product return rate in 2005 was negligible.                                                                                                                                                                                                                                                                                        

Enterprise security

We
provide organizations with tools that allow only authorized personnel to access
their networks, as well as provide protection to their networks from malicious
code. We believe that our enterprise security solutions have the following
benefits:

Authentication

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Comprehensiveness. eToken offers a full
  strong authentication and password management solution, comprised of devices,
  applications, and a management system. All eToken products are interoperable
  so the solution can be easily adapted to customers specific needs.                                                                                                                                                                                             
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Enhanced security. eToken offers smart card
  based devices which provide highly secure storage of encryption keys and
  credentials as well as on-board cryptographic operations. The eToken
  authentication technology using hardware-based cryptographic
  challenge-response enhances security and is not available in competing
  authentication technologies such as biometrics, passwords and software-based
  tokens, which do not utilize a hardware component.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Cost effectiveness. Our advanced USB token
  implementation provides a cost-effective solution due to instant USB
  connectivity offered by most PCs and laptops today making a special separate
  smart card reader redundant. Our architecture, which is based on the standard
  operating system interfaces, can eliminate the need for a back-end server,
  reducing the cost of implementing the solution. Our standard USB                                         

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|  |                                                                                                                                                                                                                                                                                
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  | token draws
  its power from the USB port which eliminates the need for batteries and
  enables its use indefinitely unlike competing technologies. The result is a
  highly cost effective solution for implementing strong user authentication.                              
|  |                                                                                                                                                                                                                                                                                
| | Product quality and ease of use. Years of
  adaptation to mainstream security applications and rigorous field testing,
  combined with an emphasis on ease of use, has positioned the eToken solution
  as one of the most advanced, robust and simple solutions in the market.

Content security

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Proactive security. Unlike our competitors
  who offer reactive gateway solutions, our eSafe solution also contains a
  proactive content security engine that preemptively blocks new Internet-borne
  threats and malicious content.                                                                                                                                                                                                                                                         
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | Integrated content security. Our
  gateway-based solution provides an integrated content security approach that
  addresses all types of content security threats in one centrally managed
  solution. By providing an integrated security solution, we can address
  blended threats of spyware, spam, viruses, worms, unauthorized peer-to-peer
  traffic and phishing. Many of our competitors focus either on antivirus or
  anti-spam solutions and do not provide an integrated solution.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | Faster and more reliable performance. We
  believe that our technology allows our eSafe products to perform faster and
  more reliably than our major competitors products. In addition, unlike our
  competitors, our built-in load balancing and fail-over capabilities ensure
  uninterrupted operation of the system without requiring investment in third
  party applications.                                                                                                          
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | Faster implementation. Installation of eSafe
  is simple and concluded in minutes, without the need to install a separate
  operating system or proprietary hardware. Most of our competitors require the
  purchase of dedicated hardware.                                                                                                                                                                                                                                                    

Our Strategy

Our
objective is to be the leading provider of security solutions to protect
digital assets and enable secured e-business. To achieve this objective, we are
pursuing the following strategies:

Extend our
technology and introduce new products

We
intend to leverage our technology, product strengths and expertise to further
expand our core product functionality and continue to develop complementary
solutions. We will continue to invest in research and development and expect to
announce several new product and technology offerings during 2006. Current
initiatives include developing a unified hardware and software solution for
software DRM based on our HASP solution; expanding our eToken line of products,
including an innovative biometric solution, a smart card token with combined
flash memory for mass data storage, and a Java card based token; and developing
additional proactive technologies to fight content security threats.

Provide
customer focus to leverage our existing customer base

We
believe our dedication to customer service has fostered significant loyalty
within our customer base and that a significant portion of our revenues in 2005
were from repeat customers. In addition, we believe that our established
enterprise security customer base represents a significant opportunity to
cross-sell our other enterprise solutions.

Establish new
strategic OEM relationships and other distribution channels

We
market our enterprise security products, eToken and eSafe, through indirect
channels, including distributors, value-added resellers and system integrators,
and in the last two years, through OEM relationships. We believe that this
strategy allows us to provide our security solutions to the largest number of
end-users. We intend to

17

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increase our channel sales to accelerate the
growth of our enterprise security segment particularly by establishing OEM
relationships with large technology vendors. For example, in the first quarter
of 2006, we announced an OEM relationship with RSA Security Inc. for our eToken
products which represented a second phase to the patent licensing agreement we
entered into with RSA Security Inc. in January 2005.

Pursue
strategic acquisitions

Over
the last decade, we have completed and integrated several acquisitions that
have expanded our product lines and customer base. While we believe our current
platform
will enable us to achieve our strategic goals, we will continue to seek
acquisitions of businesses,
products or technologies that we believe will expand our product lines and both
expand and further penetrate our customer base.

Our Products

Our
products are organized into two segments: software DRM and enterprise security.

Software DRM

Our
HASP product line is a comprehensive software DRM solution for software
publishers software protection, secure software licensing and secure software
distribution needs. Software publishers can choose from hardware-based (HASP
HL) and software-based (HASP SL) options. Hardware-based options are available
in a variety of form factors including USB, parallel port and PC-card.

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | HASP HL
  operates by receiving encrypted strings during runtime from the protected
  application and decrypting them in a way which is very difficult to imitate.
  The encryption/decryption key is vendor unique. This encryption key is
  securely stored in the HASP HL key. Only the specific vendors HASP HL keys
  decrypt correctly the encrypted strings and allow them to run properly on the
  computer. HASP HL also contains the infrastructure and tools to create and
  enforce licensing terms. These enable the creation of a wide variety of
  licensing models such as software subscription, software rental,
  module/feature licensing and trialware.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | HASP HL Net,
  our most sophisticated hardware-based key, protects software developers from
  theft and misuse of their products in the network environment. A single key,
  connected to any computer on the network, protects software against illegal
  use, limits the number of users who can access the application concurrently
  and controls access to up to 112 software modules and packages.                                                                                                                                                                                                                                                                     
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | HASP SL is a
  software-based licensing, software protection and distribution system that
  protects software copyright and intellectual property and reduces costs for
  secure distribution via CD-ROM, ESD or peer-to-peer networks.                                                                                                                                                                                                                                                                                                                                                                                                                                      

Enterprise Security

Our
enterprise security products address both safe network access (eToken) and
exclusion of bad traffic (eSafe).

eToken. eToken is a fully portable solution
for strong user authentication and password management. Our eToken USB-based
smart card authentication devices are intended to ensure that only legitimate users
gain access to network or PC resources by requiring that the users token be
inserted into the computers USB port combined with a password to ensure strong
two-factor authentication. The eToken family includes the following products:

|  |                                                                                                                                                                                                                                                                                                                                                                                                                     
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | eToken devices
including the eToken NG-OTP, a hybrid token incorporating smart card
technology with one-time password functionality for authentication in
detached mode, and eToken PRO, a two-factor authenticator that employs a
readerless smart card and is primarily used for secure network access and
digital signing. All eToken devices can integrate with proximity technology
for secure physical access.

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|  |                                                                                                                                                                                                                                                                                                                                                                    
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | eToken security applications including
  software enabling certificate based and one-time-password based strong
  authentication, and password management applications enabling secure storage
  and management of user authentication credentials on-board the token.                                                                                             
|  |                                                                                                                                                                                                                                                                                                                                                                    
| | eToken SDK (Software Development Kit) is a
  set of industry standard APIs (Application Programming Interfaces) and
  supporting documentation that enables organizations and third-party vendors
  to develop their own token-based security solutions, integrating eToken into
  their applications.                                                             
|  |                                                                                                                                                                                                                                                                                                                                                                    
| | eToken TMS (Token Management System) is a
  full system for enterprise-wide life cycle management of tokens and their
  associated security applications. This product supports applications
  including Web access, secure e-mail, data encryption, network logon and VPN
  access. It enables administrator and end users self service management
  capabilities.

eSafe. eSafe is a
gateway-based, integrated content security solution that proactively protects
networks against viruses, worms, spyware, spam and non-productive
Internet-borne content. eSafe includes antivirus, anti-spam, anti-spyware, web
filtering and protection against unauthorized peer-to-peer (P2P) traffic.
eSafes ability to block known and unknown viruses and other threats is
designed to protect critical information and reduce network and user downtime.

eSafe
incorporates our NitroInspection technology. NitroInspection allows fast
response times and has built-in fail-over and load-balancing capabilities to
enable a high volume of traffic as well as redundancy and high availability of
services in case of failures.

Sales and Marketing

Sales

We
sell our software DRM products primarily to software developers and
distributors. No one customer accounted for more than 10% of our total revenues
in 2003, 2004 or 2005.

We
market and sell our software DRM solutions directly through our head office in
Israel and through our international subsidiaries, including the United States,
the United Kingdom, Germany, Spain, Hong Kong and Japan. In addition, we have
29 distributors covering additional countries not covered by our subsidiaries.
In 2005, we recorded revenues of $34.0 million, representing 42% of our total
revenues from sales by distributors. Under the terms of our distribution
agreements, we generally grant to one distributor in each particular country or
region a non-exclusive right to market our software DRM solutions for an
initial term of one year. During this period, the distributor is required to
meet minimum sales targets set out in the distribution agreement. Following the
expiration of the initial period, the distribution agreement with each
distributor is automatically renewed, unless we or the distributor give prior
written notice. Each distributor is responsible for preparing and submitting to
us for approval a marketing plan for sales in that distributors sales
territory and for obtaining and maintaining any local regulatory approvals
required to sell our software DRM solutions in that territory.

We
market and sell our enterprise security solutions, eSafe and eToken, through
indirect channels, which include distributors, value-added resellers and system
integrators. In addition to selling our enterprise security solutions through
channel distributors, we are pursuing a strategy to establish OEM relationships
with large technology vendors. In February 2006, we announced an agreement with
RSA Security Inc., according to which RSA Security Inc. will release a new RSA
SecurID® authenticator that incorporates the Aladdin eToken USB technology.

We
are also continuing our OEM agreements with VeriSign, Inc. and Cisco Systems.
VeriSign uses our eToken NG-OTP with OTP functionality and our eToken PRO
token, for its Unified Authentication program since 2004. Cisco Systems has
incorporated USB ports and our eToken technology in its series of routers,
introduced in February 2005. These routers enable Cisco customers to easily use
our eToken products for router provisioning and secure VPN access.

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Marketing

We
conduct a number of marketing activities to support the sale and distribution
of our products. These activities are designed to inform existing and potential
customers about the capabilities and benefits of our products. These marketing
activities include:

|  |                                                                              
|- | -----------------------------------------------------------------------------
| | press
  releases and management of analyst relationship;                     
|  |                                                                              
| | direct mail,
  email and channel-related campaigns;                          
|  |                                                                              
| | participation
  in product and technology conferences and trade shows;       
|  |                                                                              
| | advertising
  in trade magazines and on the Internet;                        
|  |                                                                              
| | search
  engine optimization and search engine marketing; and                
|  |                                                                              
| | development
  and ongoing maintenance of our web site, intranet and extranet.

Competition

Software DRM

Our
software DRM solutions compete with hardware-based systems and software-based
systems. In the hardware-based software licensing authentication token, or
SLAT, market, we compete principally with SafeNet (which about two years ago
acquired Rainbow Technologies) and which, according to IDC, had a 33.2% market
share in 2004, compared to our 37.2% market share. We also compete in the SLAT
market with a number of smaller vendors including WIBU Systems AG. In the
software-based software protection market, we face competition from a larger
number of vendors, primarily Macrovision Corporation and SafeNet, which provide
software solutions for distribution and licensing.

Enterprise Security

Authentication. In the strong, or two-factor,
authentication market, our eToken product line competes principally with smart
cards and traditional strong authentication tokens, including OTP tokens, which
are currently the dominant method of strong authentication. In addition, our
eToken product line competes with other USB-based authentication systems. One
of our competitors in the authentication market is RSA Security Inc. which holds
a dominant position in the traditional authentication token market, in addition
to VASCO Data Security International, Inc. and ActivIdentity Corp. We have
recently entered into licensing and OEM agreements with RSA Security Inc. Our
principal competitor in the USB-based strong authentication market is SafeNet,
in addition to Gemplus Incorporated S.A. and Eutron SpA. According to IDC,
SafeNet accounted for 29.1% of the global USB hardware authentication market in
2004, while we accounted for 21.7% of the market.

Content
security.Our primary competitor in the content
security market for gateway solutions is Trend Micro Inc., which holds a
dominant position in this market. The overall content security market is
characterized by a small number of large companies, such as Symantec
Corporation, McAfee Inc. and Trend Micro, which together in 2005 accounted for
over 60% of global revenues in this market, as well as a large number of small
companies. While the products marketed by these companies are primarily desktop
or network server solutions and not the gateway solution eSafe provides, we may
face competition from these companies in the future if they decide to develop
gateway solutions. Vendors of firewalls might decide to extend their offerings
to gateway security, and these could compete with our eSafe product.

Intellectual Property

We
have devoted 20 years to the development of proprietary information security
technologies. We have also made certain strategic acquisitions that have enabled
us to add significant technologies to our intellectual property portfolio.

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Our
intellectual property rights are important to our business. We rely on a
combination of patents, copyrights, trademarks, trade secrets and
confidentiality clauses and other protective clauses in our agreements to
protect our intellectual property. We require employees and independent
contractors to enter into confidentiality agreements and assignments of
intellectual property rights upon the commencement of their employment and
commercial relationships with us.

The
software industry is characterized by constant product changes resulting from
new technological developments, performance improvements and lower hardware
costs. We believe that our future growth depends to a large extent on our
ability to be an innovator in the development and application of hardware and
software technology. We have adopted a policy of registering patents to protect
our core technologies.

We
cannot be certain that any patents, or patents that are advantageous to us,
will be issued. On January 31, 2005, we announced that RSA Security Inc. has
licensed two of our patents relating to our eToken technology. We believe that
this license to a market leader in strong, two factor authentication technology
supports the strength of our intellectual property portfolio in this segment of
our business. As of December 31, 2005, we had 20 granted U.S. patents and 54
pending applications in the United States. We also had 7 granted patents
outside the U.S. and 27 pending applications outside of the United States.

Government Regulation

Regulation of Encryption Technologies

Our
eToken and HASP product lines contain encryption technologies which require a
permit from the Israeli government for their development and export. We have
obtained a general permit for our HASP HL product, which does not require
renewal, and we have a special permit to export eToken, which requires annual
renewal. The
sale of eToken in some countries may require special approval by the Israeli
government, per sale, and there can be no guarantee that the Israeli government
will provide such approval. In addition, we may need to apply for additional
permits in the future to export products currently under development that
include encryption technologies. There can be no guarantee that the Israeli
government will grant such permits. Furthermore, the laws or regulations
governing the export of encryption technologies may change and we may be
required to comply with more stringent requirements. We also conduct
some of our research and development activities in Germany and may be subject
to regulations regarding export of technologies.

In
addition, the import and sale of products containing encryption technologies
are subject to various regulations in the countries in which we sell our
products. Our independent distributors are contractually responsible for
compliance with any governmental regulations in countries in which they sell
our products, and we rely upon them to fully comply with these regulations. We
are responsible for compliance with governmental regulations in countries or
regions in which we make direct sales of our products through our subsidiaries.
We have not conducted a survey of applicable governmental regulations in the
jurisdictions in which we make direct sales and we have not conducted an audit
of our independent distributors to determine their compliance with applicable
governmental regulations. Therefore, we or our subsidiaries may be noncompliant
with the laws and regulations of these jurisdictions, and could face fines,
penalties or other sanctions, including limitations on the ability to sell our
products.

Environmental Regulation

Our
European activities also require us to comply with European Union Directives
with respect to product quality assurance standards and environmental
standards. Directive 2002/95/ec of the European Parliament on the Restriction
of the Use of Certain Hazardous Substances in Electrical and Electronic
Equipment (the RoHS Directive) which will take effect on July 1, 2006. This
directive provides that producers of electrical and electronic equipment may
not place new equipment containing lead, mercury and certain other materials
deemed to be hazardous, in amounts exceeding the set maximum concentration
values, on the market in the European Union. Certain of our products must be
modified to meet this regulation, and some of our distributors and customers
are already requiring us to comply with these new rules so as not to be left
with noncompliant inventory when the directive takes effect. Complying with
this directive will impose some additional costs and administrative burden on
us. European Directive 2002/96/EC on waste, electrical and electronic
equipment, know as the WEEE Directive,

21

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makes manufacturers of electrical and electronic
equipment financially responsible for specified collection, recycling,
treatment and disposal of past and future covered products. The WEEE Directive
became effective on August 13, 2005. We may incur financial responsibility for
the collection, recycling, treatment or disposal of products covered under the
WEEE Directive. Because the EU member states have not fully implemented the
WEEE Directive, the nature and extent of the costs to comply and fees or penalties
associated with noncompliance are unknown at this time. Costs to comply with
the WEEE Directive and similar future legislation, if applicable, may also
include legal and regulatory costs and insurance costs. We may also be required
to take reserves for costs associated with compliance with these regulations.

Manufacturing

The
manufacturing process of our hardware-based products, which consists of tokens
for our HASP and eToken products, involves the assembly of purchased components
and sub-assemblies. We have one production facility in Kiryat Gat, Israel.
After assembly, each hardware-based product is tested and packaged. In the
future, we may enter into arrangements with subcontractors with respect to the
assembly of our products. We believe that our current manufacturing facility,
together with any future arrangements with subcontractors, will be sufficient
to meet the projected demand for our products.

We
purchase both custom and off-the-shelf components from a number of suppliers.
Except as described below, the components we purchase can be obtained from more
than one supplier, although in some cases lead-time may be required in order to
change suppliers. We rely on a number of single source suppliers for the
following key components of our hardware-based products:

|  |                                                                                                                                                 
|- | ------------------------------------------------------------------------------------------------------------------------------------------------
| | HASP.We obtain
  each of the application specific integrated circuits and microcontrollers
  included in HASP from sole source suppliers.       
|  |                                                                                                                                                 
| | eToken.We obtain
  the microcontroller and the smart card, including its operating system, for
  our eToken products from sole source suppliers.

We
do not have any long term supply arrangements with any of our suppliers with
respect to these key components. We estimate that it would take between six
months and one year to find alternate suppliers for these key components and
modify our products to incorporate them. We believe that our inventory of each
of the key components referred to above is sufficient to enable us to continue
manufacturing our products in the event that we need to change one of our
single source suppliers. Nevertheless, we may encounter delays or difficulties
in redesigning our products and may not be able to locate alternate suppliers
on a timely basis. If an adequate supply of any of these components is not
obtained in a timely manner or at all, we may have difficulty meeting our
production needs.

We
license the anti-spam and web filtering functions incorporated in our eSafe
product pursuant to a license agreement which automatically renews for
successive one-year terms The first renewal period expired on December 31, 2005
and following the first renewal period the agreement automatically renews for
unlimited successive one year terms subject to either partys request to
terminate at the end of the initial term or any extension. We pay our licensor
royalties consisting of a percentage of our revenues from eSafe. In the event
that our licensor cancels this license arrangement with us, we will be required
to seek an alternate licensor for these functions.

C. ORGANIZATIONAL STRUCTURE

We are organized under
the laws of the State of Israel. We wholly own the subsidiaries listed below
directly or through other subsidiaries, unless otherwise specified in the
footnotes below. These subsidiaries are involved in distribution, support for
and management of our products:

|Name of Subsidiary                                                               | Country of Incorporation           
|-------------------------------------------------------------------------------- | -----------------------------------
|Aladdin Knowledge Systems, Inc.                                                  | United States of America (New York)
|Aladdin Japan & Co. Inc.                                                         | Japan                              
|Aladdin Western Europe Ltd. (formerly Aladdin
        Knowledge Systems UK Ltd.) | England and Wales                  
|Aladdin Asia Limited (1)(2)                                                      | Hong Kong                          

22

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|    |                                                                                                                                           
|--- | ------------------------------------------------------------------------------------------------------------------------------------------
|(1) | 99% owned by Aladdin Knowledge Systems Ltd., with
  the remaining 1% shareholding owned by our wholly-owned holding company,
  Hafalad BV.
|(2) | We also established a representation office in
  China, with one employee, reporting to Aladdin Asia Ltd.                                 

Halafad
BV, our wholly-owned holding company, incorporated in The Netherlands has the
wholly-owned subsidiaries listed below. These subsidiaries are all involved in
distribution, support and management of our products. In addition, our German
subsidiary provides us with research and development services:

|Name of Subsidiary                                                   | Country of Incorporation
|-------------------------------------------------------------------- | ------------------------
|Aladdin Western Europe BV                                            | The Netherlands         
|Aladdin Western Europe S.A.R.L. (formerly Aladdin
      France S.A.) | France                  
|Aladdin Knowledge Systems España S.L.                                | Spain                   
|Aladdin Knowledge Systems Deutschland GmbH                           | Germany                 
|Aladdin Knowledge Systems Italy SRL                                  | Italy                   

D. PROPERTY, PLANTS AND EQUIPMENT

Our
corporate headquarters and principal research and development facilities are
located in a 29,121 square foot facility in Tel Aviv, Israel. The lease for
this facility expires in August 2006. In August 2006, we plan to move our corporate headquarters and principal
research and development facility to a new building in the Kiryat Arye
industrial area of Petach Tikva. The term of our lease for the new 49,514
square foot facility is 5 years, with an option to extend the lease for 5 more
years. Our manufacturing facility is located in a 10,521 square foot
facility in Kiryat Gat, Israel. We lease this facility pursuant to a lease that
expires in December 2006 which we will either extend or move to a new location.
We also lease an 11,883 square foot facility in Tirat Hacarmel, Israel for a
term expiring in December 2007, where our content security research and
development activities are headquartered.

Our
subsidiaries also lease facilities in France, Germany, Japan, the Netherlands,
the United Kingdom, Spain, Hong Kong and the United States. These facilities
are primarily for sales and marketing functions. We also conduct research and
development activities at our facilities near Munich, Germany.

Our
aggregate annual lease expenses in 2005 for our facilities were $1.8 million.
We believe that our current facilities together with our planned new corporate
headquarters and principal research and development facility are adequate for
our current and foreseeable needs. We believe we will be able to find alternate
facilities if we require them or if we are unable to renew our existing leases
on reasonable terms or at all.

Item
4A. Unresolved Staff Comments.

Not
applicable.

Item 5.
Operating and Financial Review and Prospects.

You should read the following discussion together with our
consolidated financial statements, related notes and other financial
information included elsewhere in this annual report. This discussion may
contain predictions, estimates and other forward-looking statements that
involve risks and uncertainties, including those discussed under Risk Factors
and elsewhere in this report. These risks could cause our actual results to
differ materially from any future performance suggested below.

23

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OVERVIEW

We
are a global provider of security solutions that reduce software theft,
authenticate network users and protect against unwanted Internet- and
e-mail-borne content, including spam and viruses. Our products are organized into
two segments: software digital rights management, or DRM, and enterprise
security. Our software DRM products allow software publishers to limit revenue
loss from software theft and piracy. Our enterprise security solutions enable
organizations to secure their information technology assets by controlling who
has access to their networks (authentication) and what content their users can
utilize (content security).

We
were established in 1985 with our principal focus on software protection through
our HASP product line. In the past ten years, we completed five acquisitions of
businesses and product lines which broadened our product offering and enhanced
our research and development, direct marketing and selling capabilities. We
acquired our eSafe product line at the end of 1998. In 1999, we entered the
enterprise security market by complementing eSafe with our eToken product line.
As a result of the additional expenses incurred in this transition, as well as
generally adverse economic conditions, we incurred net losses in 2001 and 2002.
In 2003 and subsequent interim periods, we returned to profitability. At the
beginning of 2004, we constituted our enterprise security segment as a separate
reportable segment. In 2005, we generated 69% of our revenues from our software
DRM segment and the balance from our enterprise security segment.

Reportable
segments

We
have two reportable segments: software security (DRM) and enterprise security.
These segments are strategic business units that offer different products to
different types of customers and are managed separately because each segment
requires different marketing strategies. Increased adoption of our eToken and
eSafe products has driven rapid growth of our enterprise security segment. The following
table sets forth information for the periods indicated regarding the percentage
of our revenues derived from each of our business segments:

|                    |  |                                 |  |      |   |      |  |  |    |   |  |  |  |    |   | 
|------------------- |  | ------------------------------- |  | ---- | - | ---- |  |  | -- | - |  |  |  | -- | - | 
|                    |  | Year ended
        December 31, | 
|                    |  | 2003                            |  | 2004 |   | 2005 | 
|                    |  |                                
|Software DRM        |  |                                 |  | 80   | % |      |  |  | 73 | % |  |  |  | 69 | % | 
|Enterprise security |  |                                 |  | 20   |   |      |  |  | 27 |   |  |  |  | 31 |   | 

Revenues

We
generate revenues from two main sources: sales of hardware products and
software licenses. To date, we have derived the substantial majority of our
revenues from sales of hardware products, although our software licenses have
increased as a percentage of sales over the past three years.

In
2004 and 2005, part of our revenues was denominated in Euros, Japanese Yen and
British pounds. When translating these revenues into U.S. dollars for the
purposes of preparing our consolidated financial statements, our reported
revenues are affected. In our period to period discussion below, we have
indicated the effects of currency fluctuations on our revenues in our reported
segments. We also refer you to Item 11,Quantitative and Qualitative
Disclosures About Market Risk below in this report for disclosure of the
effect of changes in exchange rates on our overall revenues, gross profit and
operating income for the years ended December 31, 2003, 2004 and 2005.

Revenue
recognition

Product
revenues.Revenues from product sales are recognized when
persuasive evidence of an arrangement exists, delivery of the product has
occurred, the fee is fixed or determinable, collectibility is probable and we
do not have any obligation to customers after the date on which products are
delivered.

Software
licenses.We enter into perpetual licenses and, in some
cases, time-based licenses, with purchasers of eSafe. Time-based licenses are
mostly for one- or two-year periods with respect to additional functionalities
of eSafe, such as anti-spam, web and application filtering. In both cases,
license fees are recognized

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when persuasive evidence of an agreement exists,
delivery of the product has occurred, no significant obligations with regard to
implementation remain, the fee is fixed or determinable and collectibility is
probable.

We
provide maintenance and support services to purchasers of perpetual licenses.
We determine the fair value of the maintenance and support component, which
includes the right to periodic updates when and if available, based on the
price charged by us for such maintenance and support when provided separately.
Maintenance and support revenue is deferred and recognized on a straight-line
basis over the term of the maintenance and support agreement, which is
typically one year.

Time-based
licenses include maintenance and support, which includes the right to periodic
updates when and if available. License fees from time-based licenses, and the
maintenance and support component, are recognized on a straight-line basis over
the term of the license arrangement.

Our
deferred revenues as of December 31, 2004 and 2005 were $4.8 million and
$5.6 million; respectively. The increase was primarily due to an increase in
time-based license revenues.

Revenue
trends and drivers

Customer
concentration.We sell our products to a large number of
customers. In the past three years, no one customer accounted for more than 10%
of our revenues.

Geographic
breakdown.The following table sets forth the geographic
breakdown of our revenues for the periods indicated:

|                           |  |                                 |  |      |   |      |  |  |    |   |  |  |  |    |   | 
|-------------------------- |  | ------------------------------- |  | ---- | - | ---- |  |  | -- | - |  |  |  | -- | - | 
|                           |  | Year ended
        December 31, | 
|                           |  | 2003                            |  | 2004 |   | 2005 | 
|                           |  |                                
|United States              |  |                                 |  | 32   | % |      |  |  | 29 | % |  |  |  | 33 | % | 
|Europe (excluding Germany) |  |                                 |  | 25   |   |      |  |  | 27 |   |  |  |  | 26 |   | 
|Germany                    |  |                                 |  | 22   |   |      |  |  | 22 |   |  |  |  | 21 |   | 
|Japan                      |  |                                 |  | 13   |   |      |  |  | 13 |   |  |  |  | 11 |   | 
|Israel                     |  |                                 |  | 4    |   |      |  |  | 4  |   |  |  |  | 4  |   | 
|Others                     |  |                                 |  | 4    |   |      |  |  | 6  |   |  |  |  | 5  |   | 

Repeat
customers.We consider the proportion of our revenues from
repeat customers to be an important tool in analyzing our business in our
software DRM segment. We believe that a significant portion of our revenues in
2005 was from repeat customers.

Cost of
revenues and gross profit

Software
DRM.Cost of revenues for our software DRM products consists
primarily of the cost of components, manufacturing costs (including costs of
subcontractors), salaries and related personnel expenses for employees engaged
in the manufacture and support of our products, and an allocation of overhead
and facilities costs.

Enterprise
security.Cost of revenues for our eToken products consists
primarily of the cost of components, manufacturing costs (including costs of
subcontractors), salaries and related personnel expenses for employees engaged
in the manufacture and support of our products, and an allocation of overhead
and facilities costs. Cost of revenues for eSafe consists primarily of costs
associated with the provision of technical support and royalties payable to
third-party licensees.

Our
gross margin is impacted principally by the mix of hardware- and software-based
solutions that we sell due to the higher cost of revenues associated with
hardware-based solutions.

25

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Operating
expenses

Research
and development.Research and development expenses consist
primarily of salaries and related expenses. Other such expenses include
subcontractor costs related to the design, development and testing of new
products and technologies, product enhancements and an allocation of overhead
and facilities costs. All research and development costs are expensed as
incurred.

Selling
and marketing.Selling and marketing expenses consist
primarily of salaries and related expenses, commissions, participation in our
distributors marketing efforts, as well as travel and an allocation of
overhead and facilities costs.

General
and administrative.General and administrative expenses
consist primarily of salaries and related expenses for executive, accounting,
finance, legal and litigation, human resources, administrative, network and
information systems personnel. Other such expenses include facilities
maintenance, professional fees, allowance for bad debt, goodwill amortization
and other general corporate expenses.

Financial
income, net.Financial income, net, consists primarily of
interest earned on bank deposits net of bank charges, impairment of our
investments in marketable securities, and foreign currency gains or losses.

Taxes
on income.Although Israeli companies generally are subject
to income tax at the corporate rate of 34% in 2005, we benefit from Israeli
government tax exemption programs that reduce our effective tax rate as
described under the caption Corporate Tax.

CRITICAL
ACCOUNTING POLICIES AND ESTIMATES

Our
consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States, or GAAP. The preparation of
our financial statements requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities, based upon information available at the
time, historical experience and various other factors that are believed to be
reasonable under the circumstances. These estimates are evaluated by us on an
on-going basis. Actual results may differ from these estimates under different
conditions. We believe that the application of the following critical
accounting policies entails the most significant judgments and estimates used
in the preparation of our consolidated financial statements:

Allowance
for doubtful accounts

We
are required to perform ongoing credit evaluations of our trade receivables and
maintain an allowance for doubtful accounts, based upon our judgment as to our
ability to collect outstanding receivables. Provisions are made based upon a
specific review of all the outstanding invoices. In determining the provisions,
we analyze our historical collection experience, current economic trends and
the financial position of our customers. If the financial condition of our
customers deteriorates, our revenues might be limited and additional allowances
might be required. As of December 31, 2005, our allowance for doubtful
accounts was $377,000 and our trade receivables were $13.9 million. To date,
our allowances for doubtful accounts have been sufficient.

Inventories

Inventories
are stated at the lower of cost or market value. Cost is determined by the
moving average cost method. We periodically evaluate our quantities on hand
relative to current and historical selling prices and historical and projected
sales volume. Based on these evaluations, inventory write-offs and write-down
provisions are provided to cover risks arising from slow moving items. If the
future market conditions are less favorable than our projections, additional
inventory write-downs may be required and would be reflected in cost of sales
in the period the revision is made.

SFAS
123R

26

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In
December 2004, the Financial Accounting Standards Board issued Statement No.
123 (revised 2004), Share-Based Payment (SFAS No. 123(R)), which replaces SFAS 123 and supersedes
APB 25. SFAS No. 123(R) requires
all share-based compensation to employees, including grants of employee stock
options, to be recognized in the financial statements based upon fair value,
beginning with the first interim or annual period after December 15, 2005, with
early adoption encouraged. We have the option to choose either the modified
prospective or modified prospective method. We currently expect to adopt SFAS
No. 123(R), using the modified
prospective method of adoption which requires that compensation expense be
recorded over the expected remaining life of all unvested stock options and
restricted stock and for any new grants thereof at the beginning of the first
quarter of adoption of SFAS No. 123(R). We are currently evaluating the impact FAS 123(R) will have on our
financial statements, and based on our preliminary analysis, we expect that,
the adoption of this standard will reduce our net income in 2006 by $1.5 to
$2.0 million. This estimate is based on the number of options currently
outstanding and exercisable and could change based on the number of options
granted or forfeited in fiscal 2006.

Taxes on
income and deferred tax

We
account for income taxes using the asset and liability method. Deferred tax
assets net of valuation allowances, totaled $2.4 million as of
December 31, 2005. Deferred tax assets, related valuation allowances and
deferred tax liabilities are determined separately by tax jurisdiction. We
believe sufficient uncertainty exists regarding our ability to realize our deferred
tax assets in certain foreign jurisdictions and, accordingly, a valuation
allowance has been established against the deferred tax assets in those
jurisdictions. We believe that it is more likely than not that the results of
future operations will generate sufficient taxable income to utilize the
remaining deferred tax assets, net of valuation allowances. While we have
considered future taxable income and ongoing tax planning strategies in
assessing the need for any valuation allowance, in the event we were to
determine that we will be able to realize our deferred tax assets in the future
in excess of the net recorded amount, an adjustment to the valuation allowance
would increase income in the period such a determination is made. Likewise,
should we determine that we would not be able to realize all or part of our net
deferred tax assets in the future, an adjustment to the valuation allowance
would be charged to income in the period such a determination is made. Our
effective tax rate is directly affected by the relative proportions of revenue
and income before taxes generated in different tax jurisdictions, as well as
the estimated level of annual pre-tax income. We are also subject to changing
tax laws in the multiple jurisdictions in which we operate.

Tax
returns are subject to audit by various taxing authorities. Although we believe
that adequate accruals have been made for unsettled issues, additional gains or
losses could occur in future years from resolution of outstanding matters. We
continue to assess our potential tax liability included in accrued taxes in the
consolidated financial statements, and revise our estimates accordingly. Such
revisions in our estimates could materially impact our results of operations
and financial position.

Goodwill

Under
Statement of Financial Accounting Standard No. 142, Goodwill and Other
Intangible Assets (SFAS No. 142), goodwill acquired in a business
combination that closes on or after July 1, 2001 is deemed to have
indefinite life and will not be amortized. SFAS No. 142 requires goodwill
to be tested for impairment on adoption and at least annually thereafter or
between annual tests in certain circumstances, and written down when impaired,
rather than being amortized as previous accounting standards required. Goodwill
is tested for impairment by comparing the fair value of the reporting unit with
its carrying value. Fair value is determined using the income approach.
Significant estimates used in the methodologies included estimates of future cash
flows and estimates of discount rates. As of December 31, 2005, we had
total goodwill of $7.7 million on our balance sheet. In assessing the
recoverability of our goodwill and other intangible assets, we must make
assumptions regarding the estimated future cash flows and other factors to
determine the fair value of the respective assets. If these estimates or their
related assumptions change in the future, we may be required to record
impairment charges for these assets.

Impairment
of long-lived assets

Under
Statement of Financial Accounting Standard No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, long-lived assets, such as
property and equipment, and purchased intangibles subject to amortization, are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying

27

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amount of an asset group may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison of the
carrying amount of an asset group to estimated undiscounted future cash flows
expected to be generated by the asset group. If the carrying amount of an asset
group exceeds its estimated future cash flows, an impairment charge is
recognized in the amount by which the carrying amount of the asset group
exceeds the fair value of the asset group. Assets to be disposed of would be
separately presented on the balance sheet and reported at the lower of the
carrying amount or fair value less costs to sell, and would no longer be
depreciated. The assets and liabilities of a disposal group classified as held
for sale would be presented separately in the appropriate asset and liability
sections of the balance sheet. In 2003, 2004 and 2005, no impairment charges
were recorded for long-lived assets.

Investment
in other companies

We
have investments in two related investment funds managed by Tamir Fishman
Ventures Management II LLC. In addition, we have invested in IDesia Ltd.
(formerly known as C-Signature Ltd.), an Israeli company engaged in biometric
identity recognition technology. The investments are stated at cost since we do
not have the ability to exercise significant influence over operating and
financial policies of the investee. Our management reviews our investment for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an investment may not be recoverable.

Litigation

Management
sets aside liabilities related to litigation brought against us when the amount
of the potential loss can be estimated. Because of the uncertainties related to
an unfavorable outcome of litigation, and the amount and range of loss on
pending litigation, management is often unable to make an accurate estimate of
the liability that could result from an unfavorable outcome. As litigation
progresses, we continue to assess our potential liability and revise our
estimates accordingly. Such revisions in our estimates could materially impact
our results of operations and financial position. Estimates of litigation
liability affect our accrued liability line item in our consolidated balance
sheet and our general and administrative expense line item in our statement of
operations.

RESULTS
OF OPERATIONS

The
following table sets forth certain statement of operations data as a percentage
of revenues for the periods indicated:

| |                                      |  |                                 |  |       |   |      |  |  |       |   |  |  |  |       |   | 
| | ------------------------------------ |  | ------------------------------- |  | ----- | - | ---- |  |  | ----- | - |  |  |  | ----- | - | 
| |                                      |  | Year ended
        December 31, | 
| |                                      |  | 2003                            |  | 2004  |   | 2005 | 
| |                                      |  |                                
| | Revenues:                            |  |                                 |  |       |   |      |  |  |       |  
| | Software
        security            |  |                                 |  | 79.5  | % |      |  |  | 73.3  | % |  |  |  | 69.2  | % | 
| | Enterprise
        security          |  |                                 |  | 20.5  |   |      |  |  | 26.7  |   |  |  |  | 30.8  |   | 
| | Total
        revenues               |  |                                 |  | 100.0 |   |      |  |  | 100.0 |   |  |  |  | 100.0 |   | 
| | Cost of revenues:                    |  |                                 |  |       |   |      |  |  |       |   |  |  |  |       |   | 
| | Software
        security            |  |                                 |  | 14.6  |   |      |  |  | 13.8  |   |  |  |  | 12.1  |   | 
| | Enterprise
        security          |  |                                 |  | 3.3   |   |      |  |  | 6.1   |   |  |  |  | 8.7   |   | 
| | Total
        cost of revenues       |  |                                 |  | 17.9  |   |      |  |  | 19.9  |   |  |  |  | 20. 8 |   | 
| | Gross
        profit                 |  |                                 |  | 82.1  |   |      |  |  | 80.1  |   |  |  |  | 79.2  |   | 
| | Operating
        expenses:          |  |                                 |  |       |   |      |  |  |       |   |  |  |  |       |   | 
| | Research
        and development     |  |                                 |  | 23.3  |   |      |  |  | 17.4  |   |  |  |  | 14.8  |   | 
| | Selling
        and marketing        |  |                                 |  | 40.2  |   |      |  |  | 35.7  |   |  |  |  | 33.0  |   | 
| | General
        and administrative   |  |                                 |  | 14.2  |   |      |  |  | 12.7  |   |  |  |  | 13.7  |   | 
| | One-time
        lawsuit charge      |  |                                 |  |      |   |      |  |  |      |   |  |  |  | 2.4   |   | 
| | Total
        operating expenses     |  |                                 |  | 77.7  |   |      |  |  | 65.8  |   |  |  |  | 63.9  |   | 
| | Operating
        income             |  |                                 |  | 4.4   |   |      |  |  | 14.3  |   |  |  |  | 15.3  |   | 
| | Financial
        income, net        |  |                                 |  | 0.9   |   |      |  |  | 0.1   |   |  |  |  | 1.3   |   | 
| | Other
        income (expenses), net |  |                                 |  | 0.0   |   |      |  |  | (0.2  | ) |  |  |  | 0.0   |   | 

28

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| |                                                  |  |  |  |      |   |  |  |  |      |   |  |  |  |      |   | 
| | ------------------------------------------------ |  |  |  | ---- | - |  |  |  | ---- | - |  |  |  | ---- | - | 
| | Income before
  taxes on income                  |  |  |  | 5.3  |   |  |  |  | 14.2 |   |  |  |  | 16.6 |   | 
| | Taxes on income                                  |  |  |  | 0.1  |   |  |  |  | 1.4  |   |  |  |  | 1.5  |   | 
| | Income before
  equity in losses of an affiliate |  |  |  | 5.2  |   |  |  |  | 12.8 |   |  |  |  | 15.1 |   | 
| | Equity in losses
  of an affiliate               |  |  |  | (0.2 | ) |  |  |  | 0.0  |   |  |  |  | 0.0  |   | 
| | Net income                                       |  |  |  | 5.0  | % |  |  |  | 12.8 | % |  |  |  | 15.1 | % | 

Year
ended December 31, 2005 compared to year ended December 31, 2004

Revenues

Total
revenues increased by 18.4% to $81.8 million in 2005 from $69.1 million in
2004.

Software
DRM.Revenues from software DRM increased by 11.7% to $56.6
million in 2005 from $50.6 million in 2004. This increase was attributable to
increased sales of our HASP products in all geographic markets. This increase
in HASP product sales resulted from an increase of 11.3% in the number of HASP
keys sold in 2005 compared to 2004.

Enterprise
security.Revenues from enterprise security increased by
36.4% to $25.2 million in 2005 from $18.5 million in 2004. This increase was
mainly attributable to an 85.6%, or $6.5 million, increase in eToken sales.
This increase in eToken sales resulted from an increase of 64.0% in the number
of eToken keys sold in 2005 compared to 2004 and due to income from the patent
license agreement with RSA Security.

Cost of
revenues

Total
cost of revenues increased by 23.1% to $17.0 million in 2005 from $13.8 million
in 2004.

Software
DRM.Cost of revenues for software DRM increased by 3.4% to
$9.9 million in 2005 from $9.5 million in 2004. This slight increase was
primarily attributable to an increase in subcontracting and overhead costs, due
to the increase in sales. Gross margin from software DRM products remained
relatively stable at 82.5% in 2005 compared with 81.2% in 2004.

Enterprise
security.Cost of revenues for enterprise security increased
by 67.5% to $7.1 million in 2005 from $4.2 million in 2004. This increase was
primarily attributable to an increase in manufacturing costs of $1.8 million
and subcontracting costs of $582,000, due to the increase in sales. Gross
margin from enterprise security decreased to 71.8% in 2005 compared to 77.0% in
2004.

Gross
profit increased by 17.1% to $64.8 million in 2005 from $55.3 million in 2004.
Our gross margin decreased to 79.2% in 2005 from 80.1% in 2004.

Research
and development

Research
and development expenses remained stable at $12.1 million in 2005 compared to
$12.0 million in 2004. As a percentage of revenues, research and development
expenses decreased to 14.8% in 2005 from 17.4% in 2004.

Selling
and marketing

Selling and
marketing expenses increased by 9.2% to $26.9 million in 2005 from $24.7
million in 2004. This increase was primarily attributable to an increase of
$1.2 million in compensation expenses and an increase of $950,000 in general
marketing expenses. As a percentage of revenues, selling and marketing expenses
decreased to 33.0% in 2005 from 35.7% in 2004.

29

---



General and administrative

General
and administrative expenses increased by 26.8% to $11.2 million in 2005 from
$8.8 million in 2004. This increase was primarily attributable to an increase
of $1.1 million in compensation expenses and an increase of $600,000 in
professional and legal fees. As a percentage of revenues, general and
administrative expenses increased to 13.7% in 2005 from 12.7% in 2004.

Operating
expenses in 2005 also included a $2.0 million one-time charge to settle a patent
lawsuit consisting of 2.4% of revenues.

Financial income, net

Financial
income, net, in 2005 was $1.0 million compared to financial income, net, of
$53,000 in 2004. This increase was primarily attributable to interest income
earned on the proceeds from our secondary offering, net of losses resulting
from currency fluctuations.

Taxes on income

Taxes
on income were $1.2 million in 2005 compared to $957,000 in 2004. In 2005,
taxes on income in the amount of $2.1 million were partially offset by an
increase in the deferred tax asset of $832,000 related to certain foreign net
operating losses carried forward and other timing differences.

Year ended December 31, 2004 compared to year
ended December 31, 2003

Revenues

Total
revenues increased by 26.3% to $69.1 million in 2004 from $54.7 million in
2003. Currency fluctuations accounted for $3.3 million of this increase.

Software
DRM.Revenues from software DRM increased by 16.4% to
$50.6 million in 2004 from $43.5 million in 2003. This increase was
attributable to increased sales of our HASP products in all geographic markets.
This increase in HASP product sales resulted from an increase of 13.6% in the
number of HASP keys sold in 2004 compared to 2003.

Enterprise
security.Revenues from enterprise security increased
by 64.9% to $18.5 million in 2004 from $11.2 million in 2003. This increase was
attributable primarily to increased revenues of $1.5 million from greater
penetration of eSafe to larger customers and increased revenues of $1.7 million
from time-based licenses for additional eSafe features. This greater
penetration of eSafe to larger customers led to an increase in the number of
the licenses sold in 2004 by 17% compared to 2003. The increased revenues from
the new time-based licenses for additional eSafe features resulted from a
significant increase in the number of sales of these licenses in 2004 compared
to 2003, when these sales had just begun and the recognized revenues were
immaterial. In addition, revenues from eToken increased by $4.0 million due to
increased market acceptance. This increase in eToken sales resulted from an
increase of 100.0% in the number of eToken keys sold in 2004 compared to 2003.

Cost of revenues

Total
cost of revenues increased by 40.6% to $13.8 million in 2004 from $9.8 million
in 2003.

Software
DRM.Cost of revenues for software DRM increased by
19.3% to $9.5 million in 2004 from $8.0 million in 2003. This increase was
primarily attributable to an increase in manufacturing costs of $953,000 due to
the increase in sales and an increase of $564,000 as a result of a reassignment
of technical support personnel from the research and development and sales
departments to customer support. Gross margin from software DRM products
remained relatively stable at 81.2% in 2004 compared with 81.6% in 2003.

Enterprise
security.Cost of revenues for enterprise security
increased by 135.0% to $4.2 million in 2004 from $1.8 million in 2003. This
increase was primarily attributable to an increase in manufacturing costs of
$1.2

30

---



million due to
the increase in sales and an increase of $920,000 as a result of a reassignment
of technical support personnel from the research and development and sales
departments to customer support. Gross margin from enterprise security
decreased to 77.0% in 2004 compared with 83.9% in 2003.

Gross
profit increased by 23.2% to $55.3 million in 2004 from $44.9 million in 2003.
Our gross margin decreased to 80.1% in 2004 from 82.1% in 2003.

Research and development

Research
and development expenses decreased by 5.7% to $12.0 million in 2004 from $12.8
million in 2003. This decrease resulted primarily from the reassignment of
technical support personnel from the research and development department to
customer support which decreased research and development costs by $454,000.
The balance of the decrease was attributable to a shift of our research and
development efforts in the software DRM segment from the United States to
Israel resulting in reduced labor and facility costs of $498,000. As a
percentage of revenues, research and development expenses decreased to 17.4% in
2004 from 23.3% in 2003.

Selling and marketing

Selling
and marketing expenses increased by 12.1% to $24.7 million in 2004 from $22.0
million in 2003. This increase was primarily attributable to an increase of
$1.2 million in salaries and an increase of $608,000 in commissions to sales
personnel, an increase of $1.1 million in general marketing expenses and an
increase of $285,000 in travel expenses. This increase was partially offset by
a decrease of $1.0 million in expenses resulting from the reassignment of
technical support personnel from the sales department to customer support. As a
percentage of revenues, selling and marketing expenses decreased to 35.7% in
2004 from 40.2% in 2003. Currency fluctuations accounted for $1.2 million
of the total increase in selling and marketing expenses in 2004.

General and administrative

General
and administrative expenses increased by 13.7% to $8.8 million in 2004 from
$7.7 million in 2003. This increase was primarily attributable to an increase
of $466,000 in salaries, mainly due to bonus expenses of $220,000, an increase
of $200,000 in amortization expenses as a result of a settlement agreement with
Aladdin Systems Holdings Inc. and an increase of $322,000 in other general
items. As a percentage of revenues, general and administrative expenses
decreased to 12.7% in 2004 from 14.2% in 2003.

Financial income, net

Financial
income, net, in 2004 was $53,000 compared to financial income, net, of $480,000
in 2003. This change was primarily attributable to the decrease in our
financial income related to foreign currency reimbursement gains resulting from
currency fluctuations.

Taxes on income

Taxes
on income were $957,000 in 2004 compared to $49,000 in 2003. Taxes on income in
2003, in an amount of $399,000, were partially offset by an increase in the
deferred tax asset of $350,000 related to certain foreign net operating losses
carried forwards.

LIQUIDITY AND CAPITAL RESOURCES

Our
primary sources of liquidity are our cash, cash equivalents and marketable
securities and our cash flow from operations as well as our secondary offering
in 2005. As of December 31, 2005, we had cash, cash equivalents and
marketable securities aggregating $77.2 million. On March 30, 2005, we
completed an underwritten public offering of 2,000,000 ordinary shares
resulting in net proceeds to us of $38.8 million after deducting the
underwriting discount and offering expenses.

Our
operating activities provided cash in the amount of $14.6 million in 2005
compared to $8.8 million in 2004. In 2005, our cash generated from operating activities
was impacted by higher net income, an increase in other

31

---



current
liabilities, trade payables and deferred revenues, which was partially offset
by an increase in trade receivables and inventory. The increase in other
current liabilities was mainly attributable to an increase in our current tax
liability. The increase in deferred revenues, trade receivables and inventory
was due primarily to the increase in our revenues in 2005 compared to 2004. Our
operating activities provided cash in the amount of $8.8 million in 2004 and
$5.9 million in 2003. In 2004, our cash generated from operating activities was
impacted by higher net income, an increase in trade payables and deferred
revenues, which was partially offset by an increase in trade receivables. The
increase in the deferred revenues and trade receivables was due primarily to
the increase in our revenues in 2004 compared to 2003.

Our
investing activities used cash in the amount of $42.7 million in 2005 mainly
consisting of an investment in available-for-sale marketable, securities in the
amount of $40.5 million and the purchase of property and equipment in the
amount of $2.3 million. Our investing activities used cash in the amount of
$13.6 million in 2004, mainly due to the acquisition of our former distributor,
Aladdin Knowledge España S.L., in the amount of $1.8 million (net of cash on
hand), an investment in Tamir Fishman Ventures II LLC in the amount of
$1.3 million, an investment in IDesia Ltd. in the amount of $1.1 million, an investment
in available-for-sale marketable securities in the amount of $7.0 million, the
purchase of property and equipment in the amount of $1.2 million and the
purchase of intangible assets in the amount of $1.2 million. Our investing
activities used cash in the amount of $2.6 million in 2003, mainly due to the
purchase of property and equipment in the amount of $913,000 and an investment
in Tamir Fishman Ventures II LLC in the amount of $1.7 million.

Our
financing activities provided cash in the amount of $39.3 million, mainly due
to proceeds from issuance of shares in 2005 and in the amount of $3.6 million
in 2004 and $456,000 in 2003 due to proceeds from the exercise of stock options
by employees.

We
had working capital of $85.0 million as of December 31, 2005, $34.1
million as of December 31, 2004 and $26.6 million as of December 31,
2003.

The
following table summarizes our contractual obligations and commercial
commitments as of December 31, 2005:

|                                        |  |                               |        |                                  |   |                 |  |                 |       |                 |   |                       |  |   |       |  |   |      
|--------------------------------------- |  | ----------------------------- | ------ | -------------------------------- | - | --------------- |  | --------------- | ----- | --------------- | - | --------------------- |  | - | ----- |  | - | -----
|                                        |  | Payment due
        by period
|Contractual obligations                 |  | Total                         |        | Less
        than 1
        year |   | 2
        years |  | 3
        years |       | 4
        years |   | After 4
        years
|                                        |  |                              
|                                        |  | (in thousands)               
|Operating leases (1)                    |  | $                             | 9,800  |                                  | $ | 2,860           |  | $               | 2,559 |                 | $ | 1,752                 |  | $ | 1,513 |  | $ | 1,116
|Purchase obligations (2)                |  |                               | 2,724  |                                  |   | 2,563           |  |                 | 161   |                 |   |                      |  |   |      |  |   |     
|Other long-term commitments
        (3) |  |                               | 1,283  |                                  |   | 1,283           |  |                 |      |                 |   |                      |  |   |      |  |   |     
|Total contractual obligations           |  | $                             | 13,807 |                                  | $ | 6,706           |  | $               | 2,720 |                 | $ | 1,752                 |  | $ | 1,513 |  | $ | 1,116

(1) Consists of operating leases for our
facilities and for vehicles.


(2) Consists of purchase orders for
components for our products. In some cases, we are entitled to terminate our
commitment upon agreed advance notice, which is subject to a penalty.


(3) In 2000, we signed an agreement with
Tamir Fishman Ventures Management II Ltd. and Tamir Fishman Ventures II
LLC pursuant to which we committed to invest up to $8.5 million (of which $7.2
million had been invested by December 31, 2005) in Tamir Fishman
Ventures II LLC at their request. We based our assumption of the timing of
future investments based on our past experience, since we cannot foresee when
the demands will be placed.


Our obligation
for accrued severance pay under Israels Severance Pay Law as of
December 31, 2005 was $3.2 million, of which $2.5 million was funded
through deposits into severance pay funds, leaving a net obligation of $0.7
million.

32

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We
believe that our accumulated cash, in conjunction with cash generated from
operations and available funds, will be sufficient to meet our cash
requirements for working capital and capital expenditures for at least the next
12 months.

INVESTMENTS

In
April 2004, the Company entered into a convertible loan agreement with IDesia
Ltd., an Israeli company engaged in the development of biometric identity
recognition technology. Pursuant to the agreement, the Company invested an
aggregate amount of $1.05 million in IDesia Ltd. In addition, the Company
incurred expenses in the amount of $50,000 in connection with this investment.
This investment consisted of a $550,000 convertible loan, which automatically
converted into Series A Preferred Shares of IDesia Ltd. upon the achievement of
certain agreed upon milestones. Concurrently with the conversion of the loan,
the Company invested the remaining $500,000 by purchasing additional Series A
Preferred Shares of IDesia Ltd.

In
October 2005, the Company signed an agreement titled License and OEM Agreement with IDesia
Ltd. Under this agreement IDesia Ltd. will develop, manufacture,
provide and license to the Company certain chip-sets for the implementation of
biometric technology as specified in the agreement. According to the agreement,
the Company advanced IDesia Ltd. an amount of $200,000 in consideration for the
committed chip-sets.

We
had invested an aggregate amount of $7.2 million as of December 31, 2005, in
two related investment funds managed by Tamir Fishman Ventures Management II
Ltd. We do not exercise any control over the operating and financial policies
of these funds and, in 2002, we recorded an impairment charge of $1.0 million
related to these investments.

We
hold investments in two companies that are traded on the Tel Aviv Stock
Exchange with a fair market value of $1.4 million as of December 31,
2005.

CORPORATE TAX

Israeli
companies generally are subject to income tax at the declining corporate rate
of 34% for the 2005 tax year, 31% for the 2006 tax year, 29% for the 2007 tax
year, 27% for the 2008 tax year, 26% for the 2009 tax year and 25% for the 2010
tax year and thereafter. We benefit from Israeli government tax exemption
programs that reduce our effective tax rate. We currently have several
effective expansion programs that have been granted approved enterprise status.
Therefore, we are eligible for tax benefits under the Israeli Law for the
Encouragement of Capital Investments, 1959. Subject to compliance with
applicable requirements, the portion of our undistributed income derived from
our approved enterprise programs was exempt from income tax during the first
two years in which these investment programs produced taxable income and are
currently subject to a reduced tax rate of zero and 10% to 25% for the
remaining eight years of the programs. In order to enjoy these benefits, we
have determined not to declare dividends or otherwise distribute earnings out
of tax exempt income. The availability of these tax benefits is subject to
certain requirements, including making specified investments in property and
equipment, and financing a percentage of investments with share capital. If we
do not meet these requirements in the future, the tax benefits may be canceled
and we could be required to refund any tax benefits that we have already
received, plus interest and penalties thereon. Since our taxable income is
derived from more than one approved enterprise program and since part of our
taxable income is not derived from an approved enterprise (including any
taxable income of our subsidiaries), our effective tax rate is a weighted
average rates based on the various applicable rate and tax exemptions.

On
April 1, 2005, the Israeli Parliament passed an amendment to the Investment
Law, in which it revised the criteria for investments qualified to receive tax
benefits. An eligible investment program under the amendment will qualify for
benefits as a privileged enterprise (rather than the previous terminology of
approved enterprise). Among other things, the amendment provides tax benefits
to both local and foreign investors and simplifies the approval process. If our
investment programs comply with the requirements of the law, we will be
entitled to certain tax benefits. We cannot assure you that any additional
investment program adopted by us in the future will comply with the
requirements of the law or that the tax benefits for investment programs
continue at current levels.

33

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As
of December 31, 2005, the net operating loss carry-forwards of our subsidiaries
for tax purposes amounted to $26.5 million, the majority of which related to
our U.S. and German subsidiaries. A subsidiarys net operating loss
carry-forwards for tax purposes relating to a jurisdiction are generally
available to offset future taxable income of such subsidiary in that
jurisdiction, subject to applicable expiration dates.

Item 6. Directors, Senior
Management and Employees.

A. DIRECTORS
AND SENIOR MANAGEMENT

Our
executive officers and directors, their ages and positions, as of the date of
this report are as follows:

|                          |     |                                                    
|------------------------- | --- | ---------------------------------------------------
|Name                      | Age | Position                                           
|Jacob
  (Yanki) Margalit  | 43  | Chairman of
  the Board and Chief Executive Officer
|Efrat Makov               | 38  | Chief
  Financial Officer                          
|Uzi Dvir                  | 38  | Chief
  Technology Officer                         
|Leedor Agam               | 42  | Vice
  President, Corporate Business Development   
|John Gunn                 | 45  | Vice
  President, Marketing                        
|David Assia(1)            | 54  | Director                                           
|Menahem
  Gutterman(1)(2) | 66  | Director                                           
|Orna
  Berry(1)(2)        | 56  | Director                                           
|Dany
  Margalit           | 38  | Director                                           

(1) Member of the audit committee and
independent director under The Nasdaq National Market listing requirements.


(2) External director under the Israeli
Companies Law.


Jacob
(Yanki) Margalitfounded our company in 1985 and has
served as our Chairman of the Board and Chief Executive Officer since 1987. Mr.
Margalit served as our Chief Financial Officer from 1987 to 1993 and has served
as a director since 1985. Jacob Margalit is the brother of Dany Margalit.

Efrat Makov
has been our Chief Financial Officer since September 2005. Before joining us in 2005, Ms. Makov served in
management positions at two Israeli-based NASDAQ-listed companies, most
recently as Vice President of Finance at Check Point Software Technologies Ltd.
Prior to that, Ms. Makov was the Director of Finance for NUR Macroprinters Ltd.
Previously, she spent seven years in public accounting with Arthur Andersen in its
New York, London and Tel Aviv offices. An Israel and U.S. Certified Public
Accountant, Ms. Makov holds a B.A. in accounting and economics from Tel Aviv
University.

Uzi
Dvir re-joined Aladdin in November 2001 as Chief
Technology Officer (CTO). Mr. Dvir has more than 20 years of experience in
software and hardware product development. Mr. Dvir first joined Aladdin in
1989 and was one of the first members of the Companys development team. Prior
to joining the Company, Mr. Dvir served as a general partner at Keren Zavit, a
small privately held investment fund that made seed and early stage investments
in hi-tech companies. Prior to that, he funded and served as VP Software
Development at Curry Software Industries, which offered off-shore software development
services from India to leading hi-tech Israeli Companies.

Leedor
Agam was appointed as Vice President of Corporate
Business Development in November 2005 after heading up the Companys portable
authentication and network security eToken Business for the past 5 years. Prior
to joining Aladdin, Mr. Agam served as Vice President of Business Development
for AR/Cylink where he focused on technology acquisitions and partnerships. He
has also held several management positions in marketing and channel management
where he gained extensive experience in bringing to market high technology
security solutions. Mr. Agam received an MBA from City University Business
School in London, and a technology bachelors degree in Industrial Management
from Shenkar Engineering College in Tel Aviv and completed the General Manager
Program (TGMP) at Harvard Business School.

John Gunn joined the Company as Vice President Global
Marketing in March of 2005. From 2002 to 2005, Mr. Gunn was employed at VisionTek,
LLC, the largest U.S.-based developer of video and memory solutions

34

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for consumer and enterprise applications where he launched a new
  division and became President of VisionTeks commercial division. Mr. Gunn
  previously worked in senior level sales and marketing positions for 3dfx and
  STB, two prominent fabless ASIC development and implementation companies. Mr.
  Gunn was also responsible for leading the launch of Packard Bells REVEAL
  peripheral products division. Mr. Gunn holds a B.A. in economics and business
  from the University of California at Los Angeles.

David
Assiahas served as a director since 1993. Mr. Assia
is a co-founder of Magic Software Enterprises Ltd., a provider of development
and integration technology, and Mashov Computers Ltd. (currently Formula
Vision), a software holding company. Mr. Assia currently serves as the
Executive Chairman of Magic Software. From 1983 to 1996, Mr. Assia was the
Chief Executive Officer and Chairman of Magic Software. Mr. Assia is also a
member of the boards of directors of Radview Software Ltd., a developer of
verification software, Babylon Ltd., a developer of translation software and
the Weizmann Institute of Science. Mr. Assia holds a B.A. in economics and
statistics and an M.B.A. from Tel Aviv University.

Dr.
Menahem Guttermanhas served as an external director
since 2000. Since January 2005, Dr. Gutterman has been the Deputy President for
Research, Development and Relations with Industry of AFEKA  Tel-Aviv Academic
College of Engineering. From 2001 until January 2005, he was a Senior Managing
Partner of Atid Capital Partners, an American/Israeli venture capital fund. Dr.
Gutterman has served as Executive Vice President and Head of the Operations
Information Systems Division of Israel Discount Bank Ltd. since 1992. Dr.
Gutterman served as General Managers Assistant at Israel Discount Bank Ltd.
from 1981 to 1992. Prior to joining Israel Discount Bank Ltd., from 1981 to
1982, Dr. Gutterman served as Vice President of Sales and Services at Elscint
Limited, a medical imaging devices company, as well as Managing Director of
Clal Systems Ltd., from 1974 to 1980. Until 2000, Dr. Gutterman served as a
senior lecturer at Tel Aviv University, Faculty Management, and School of
Business Administration. Dr. Gutterman holds a D.Sc. in mathematics from The
Technion-Israel Institute of Technology.

Dr.
Orna Berryhas been an external director since 2001.
Dr. Berry is a partner in Gemini Israel Funds Ltd. and since 2000 has served as
Chairperson of Lambda Crossing, Ltd. and Riverhead Networks, Inc., which was
sold to Cisco in March 2004. Since January 2005 she has served as Chairperson
of Adamind Ltd. Dr. Berry served as the Chief Scientist of the Ministry of
Industry and Trade of the Government of Israel from 1997 to 2000 and
Co-President of Ornet Data Communications Technologies Ltd., a provider of
high-speed switches, which was acquired by Siemens AG, from 1993 to 1997. From
1992 to 1993, Dr. Berry served as a consultant to Intel Communications
Division and Elbit Systems, Ltd. Dr. Berry holds a B.A. in statistics and
mathematics from Haifa University, an M.A. in statistics and mathematics from
Tel Aviv University and a Ph.D. in computer science from the University of
Southern California.

Dany
Margalitjoined our company in 1987 as Research and
Development Manager and has served as a director since 1994. In 1989, Mr.
Margalit was appointed Executive Vice President, Research and Development. From
1998 until April 2006, Mr. Margalit served as our Executive Vice President,
Technologies. As of April 2006, Mr. Margalit serves as an advisor to the
Company. Mr. Margalit holds a B.Sc. in mathematics and computer science from
Tel Aviv University. Dany Margalit is the brother of Jacob Margalit.

There
are no arrangements or understandings with major shareholders, customers,
suppliers or others, pursuant to which any person referred to above was
selected as a director or member of senior management.

B. COMPENSATION

For
the year ended December 31, 2005, we paid in the aggregate approximately
$1.3 million as direct remuneration to our directors and executive
officers. This amount includes directors fees and expenses, but does not
include amounts expended by us for automobiles made available to our officers,
expenses (including business travel, professional and business association dues
and expenses) reimbursed to officers and other fringe benefits commonly
reimbursed or paid by companies in Israel. In addition, we set aside or accrued
approximately $34,000 to provide pension, retirement or similar benefits.

35

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The
compensation paid to our directors, including to our directors who are also
executive officers, is subject to shareholder approval at our annual general
meeting of shareholders. The following is a summary of the terms of
compensation submitted for shareholder approval:

Non-executive
directors.In 2003, our shareholders approved the
grant to each of these directors of options to purchase 2,500 of our ordinary
shares at an exercise price of $2.67 per share vesting over a four-year period.
In 2005, we granted to each outside director options to purchase 4,000 shares
annually until such outside directors term expires, or in the case of Mr.
Assia, for three years. Our non-executive directors also receive annual fees of
$14,000 each for board and committee membership.

Jacob
(Yanki) Margalit. Effective October 2002, the annual
base salary of Jacob (Yanki) Margalit, our Chairman and Chief Executive
Officer, is $150,000. In addition, since the first quarter of 2002, Mr.
Margalit has received an annual performance-based bonus equivalent to 1.5% of
year-to-year increases in our annual revenues. Since the first quarter of 2002,
Mr. Margalit also has received a quarterly performance-based bonus equivalent
to 3.0% of our quarterly net profits. Under this arrangement, in 2005, Mr.
Margalit was entitled to a cash bonus in the amount of $561,000. In April 2003,
we granted to Mr. Margalit options to purchase 100,000 of our ordinary shares
at an exercise price per share of $1.20, representing a discount of $1.47 to
the last reported sale price of our ordinary shares on The Nasdaq National
Market on the date of grant. One-third of the options become exercisable on
each of the first three anniversaries of the date of grant. Mr. Margalit also
receives the use of an automobile from us and 25 days of paid vacation per
year, as well as other benefits commonly paid by companies in Israel.

Dany
Margalit.Effective January 2004, the annual base
salary of Dany Margalit, then our Executive Vice President, Technologies and a
director, was $144,402. In December 2003, we granted to Mr. Margalit options to
purchase 65,000 of our ordinary shares at an exercise price per share of $8.52
representing the last reported sale price of our ordinary shares on The Nasdaq
National Market on the date of grant. One quarter of the options become
exercisable on each of the first four anniversaries of the date of grant. As of
April 1, 2006, Mr. Margalit will no longer serve as Executive Vice President,
Technologies. Subject to shareholder approval, Mr. Margalit will receive his
salary at his current rate through September 2006. He will continue to serve as
a director and began serving as an advisor to the Company in April 2006.

C. BOARD
PRACTICES

Board of directors and executive officers

Our
articles of association provide that we may have up to eight directors, each of
whom, except for our external directors, is elected at an annual general
meeting of our shareholders by a vote of the holders of a majority of the
voting power present and voting at that meeting. Our board of directors
currently consists of five directors. Each director listed above will hold
office until the next annual general meeting of our shareholders, except for
our external directors whose terms will expire pursuant to the Israeli
Companies Law, 1999 as described under External Directors. Other than Jacob
(Yanki) Margalit, our Chairman and Chief Executive Officer, and Dany Margalit,
a director, none of our directors are our employees or are party to a service
contract with us.

A
simple majority of our shareholders at a general meeting may remove any of our
directors, other than our external directors, from office, elect directors in
their stead and fill any vacancy, however created, in our board of directors.
In addition, vacancies on the board of directors, other than vacancies created
by an external director, may be filled by a vote of a majority of the directors
then in office (even if less than a quorum). A director so chosen or appointed
will hold office until the next general meeting of our shareholders. Our board
of directors may also appoint additional directors up to the maximum number
permitted under our articles of association. A director so chosen or appointed
will hold office until the next general meeting of our shareholders.

External and independent directors

Under
the Companies Law, 1999, referred to as the Companies Law, companies
incorporated under the laws of Israel whose shares have been offered to the
public in or outside of Israel, are required to appoint at least two external
directors. The Companies Law provides that a person may not be appointed as an
external director if the person or the persons relative, partner, employer or
any entity under the persons control, has, as of the date of the

36

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persons
appointment to serve as external director, or had, during the two years
preceding that date, any affiliation with the company or any entity
controlling, controlled by or under common control with the company. The term
affiliation includes:

| |   |                                                                         
| | - | ------------------------------------------------------------------------
| |  | an
  employment relationship;                                           
| |  | a business
  or professional relationship maintained on a regular basis;
| |  | control; and                                                            
| |  | service as
  an office holder.                                          

No
person may serve as an external director if the persons position or other
business activities create, or may create a conflict of interest with the
persons responsibilities as an external director or may otherwise interfere
with the persons ability to serve as an external director or if the person is
an employee of the Israel Securities Authority or of an Israeli stock exchange.
If, at the time of election of an external director, all other directors are of
the same gender, the external director to be elected must be of the other
gender. External directors are elected by a majority vote at a shareholders
meeting, provided that either:

| |     |                                                                                                                                                                                                           
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | the majority
  of shares voted at the meeting, including at least one-third of the shares of
  non-controlling shareholders or their representatives voted at the meeting,
  vote in favor of election; or
| |     |                                                                                                                                                                                                           
| | (2) | the total
  number of shares of non-controlling shareholders voted against the election
  of the external director does not exceed one percent of the aggregate voting
  rights in the company.           

Pursuant
to the Companies Law, an external director must have financial and accounting
expertise or professional qualifications, provided that at least one external
director will have financial and accounting expertise. The terms financial and
accounting expertise and professional qualifications have been defined in
regulations promulgated under the Companies Law.

The
initial term of an external director is three years and may be extended for an
additional three years. Dr. Orna Berry was appointed as an external director on
December 31, 2001 for an initial three-year term and was reappointed for a
second three-year term, ending December 31, 2007. On December 16, 2003 our
shareholders reappointed Dr. Menahem Gutterman as an external director for a
second three-year term that expires on December 31, 2006.

Each
committee exercising the powers of the board of directors is required to
include at least one external director. However, the audit committee should
include all the external directors.

An
external director is entitled to compensation as provided in regulations
promulgated under the Companies Law and is otherwise prohibited from receiving
any compensation, directly or indirectly, in connection with services provided
as an external director.

In
addition to the requirements of the Israeli law, we comply with The Nasdaq
National Market listing requirements, pursuant to which our board of directors
must have at least three independent directors (including all members of our
audit committee) as defined in those rules. We believe that each member of our
audit committee currently satisfies this requirement.

Qualifications of other directors

Under
the Companies Law, the board of directors of a publicly traded company is
required to make a determination as to the minimum number of directors who must
have financial and accounting expertise according to criteria which is defined
in regulations promulgated under the Companies Law effective as of January
2006. According to the Companies Law, the determination of the board will be
based, among other things, on the type of the company, its size, the volume and
complexity of its activities and the number of directors. Based on the
foregoing considerations, our board determined that the number of directors
with financial and accounting expertise in our company shall not be less than
two. Dr. Orna Berry and Mr. David Assia qualify as having the required
financial and accounting expertise under the Companies Law.

37

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Audit committee

The
board of directors of an Israeli public company must appoint an audit committee
comprised of at least three directors, including all of the external directors.
The chairman of the board, any controlling shareholder, any relative of a
controlling shareholder, and any director employed by the company or who
provides services to the company on a regular basis (other than as a board
member) may not serve on the audit committee. Under The Nasdaq National Market
listing requirements, we are required to have an audit committee consisting of
independent directors who are financially literate and one of whom has
accounting or related financial management expertise. Currently, the members of
our audit committee are Mr. Assia, Dr. Gutterman and Dr. Berry. The rules of
the Securities and Exchange Commission require us to disclose whether one or
more members of our audit committee is a financial expert. We believe that Mr.
Assia qualifies as a financial expert under the SEC rules.

Our
audit committee assists the board of directors in fulfilling its oversight
responsibilities relating to our financial accounting, reporting and controls.
Pursuant to its charter, the audit committee is responsible for monitoring the
integrity of our financial statements and auditing, accounting and financial
reporting processes, pre-approving all auditing services and permitted
non-audit services (including the fees and other terms), evaluating the
qualifications and independence of the external auditor and detecting defects
in the management of our business through consultation with the internal
auditor. The responsibilities of the audit committee under Israeli law include
identifying irregularities in the management of the companys business, nominating
an internal auditor and approving certain related party transactions.

Internal auditor

The
board of directors of an Israeli public company must appoint an internal
auditor nominated by the audit committee. An internal auditor may not be an office
holder, or an interested party (i.e., a holder of 5% or more of the voting
rights in the company or of the issued share capital, the chief executive
officer of the company or any of its directors, or a person who has the
authority to appoint the companys chief executive officer or any of its
directors), or a relative of an office holder or of an interested party. In
addition, the companys independent accountant or its representative may not
serve as the companys internal auditor.

The
role of the internal auditor is to examine, among other things, the compliance
of the companys conduct with applicable law and orderly business procedures.
Mr. Doron Ruppin serves as our internal auditor.

Compensation and nominating committees

Our
compensation and nominating committees each consist of our independent
directors, Mr. Assia, Dr. Gutterman and Dr. Berry. In January 2005, in
accordance with the corporate governance rules of The Nasdaq National Market,
our compensation and nominating committees adopted charters, which set forth
each committees responsibilities. Pursuant to the charters, the compensation
and nominating committees are authorized to make decisions regarding executive
compensation and terms and conditions of employment, as well as to recommend
that the board of directors issue options under our stock option plans. The
compensation and nominating committees are also responsible for recommending to
the board of directors nominees for board membership. The charters require that
the composition of the committees must satisfy The Nasdaq National Markets
independent director requirements.

D. EMPLOYEES

As
of December 31, 2005, we and our subsidiaries had 400 employees of whom
232 were based in Israel, 101 in Europe, 58 in the United States and 9 in Japan
and Asia.

The
following table sets forth for the last three fiscal years the breakdown of our
employees by activity:

|                                |  |                      |     |      |  |      |  |  |     |  |  |  | 
|------------------------------- |  | -------------------- | --- | ---- |  | ---- |  |  | --- |  |  |  | 
|                                |  | As of
  December 31, |     |      |  |     
|                                |  | 2003                 |     | 2004 |  | 2005 |  |  |     | 
|Activity                        |  |                      |     |      |  |      |  |  |     | 
|Manufacturing                   |  |                      | 53  |      |  | 61   |  |  | 58  |  |  |  | 
|Research and
  development      |  |                      | 151 |      |  | 153  |  |  | 163 |  |  |  | 
|Marketing
  and sales           |  |                      | 77  |      |  | 86   |  |  | 92  |  |  |  | 
|Administration
  and management |  |                      | 70  |      |  | 76   |  |  | 87  |  |  |  | 
|                                |  |                      |     |      |  |      |  |  |     |  |  |  | 
|Total                           |  |                      | 351 |      |  | 376  |  |  | 400 |  |  |  | 

38

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Certain
provisions of the collective bargaining agreements between the Histadrut
(General Federation of Labor in Israel) and the Coordination Bureau of Economic
Organizations (including the Industrialists Associations) might be applicable
to our employees in Israel by order of the Israeli Ministry of Labor. These
provisions concern principally the length of the workday, minimum daily wages
for professional workers, insurance for work-related accidents, procedures for
dismissing employees, determination of severance pay, and other conditions of
employment. We generally provide our employees with benefits and working
conditions beyond the legal minimums. In addition to salary and other benefits,
certain of our sales personnel are paid commissions based on our performance in
certain territories worldwide. In certain European countries, restrictive labor
laws can inhibit our ability to terminate the employment of certain of our
subsidiaries employees.

E. SHARE
OWNERSHIP

All
of the persons listed above, under the caption Directors, Senior Management
and Employees who are employed by us own shares and/or options to purchase
ordinary shares. Except as set forth below, none of the named directors or
employees owns shares and/or options amounting to 1% or more of our outstanding
ordinary shares. As of June 15, 2006 Jacob (Yanki) Margalit beneficially held
1,860,795 ordinary shares which represented 13.3% of our issued and outstanding
share capital, and Dany Margalit held 891,695 ordinary shares which is 6.3% of
our issued and outstanding capital. Information regarding our share option
plans presented in Note 14D to our consolidated financial statements is
incorporated herein by reference.

Item 7. Major Shareholders and Related Party Transactions.

A. MAJOR
SHAREHOLDERS

The
following table sets forth information regarding beneficial ownership of our
ordinary shares as of the date of this report by:

|  |                                                                                                      
|- | -----------------------------------------------------------------------------------------------------
| | each
  shareholder known by us to own beneficially more than 5% of our outstanding
  ordinary shares;
|  |                                                                                                      
| | each of our
  directors and executive officers individually; and                                     
|  |                                                                                                      
| | all of our
  directors and executive officers as a group.                                            

We
have determined beneficial ownership in accordance with the rules of the
Securities and Exchange Commission. Unless indicated below, to our knowledge,
the persons and entities named in the table have sole voting and sole
dispositive power with respect to all shares beneficially owned, subject to
community property laws where applicable. Ordinary shares and options that are
currently exercisable or exercisable within 60 days after the date of this
report are deemed outstanding and beneficially owned by the person holding the
options for the purpose of computing the percentage ownership of that person,
but are not treated as outstanding for the purpose of computing the percentage
ownership of any other person. Unless indicated below, the address for each
listed shareholder is c/o Aladdin Knowledge Systems Ltd., 15 Beit Oved Street,
Tel Aviv 61110, Israel.

The
percentage of shares beneficially owned is based on 14,607,963 ordinary shares
outstanding as of June 15, 2006.

39

---



|                                                           |  |  |                                                             |  |  |                                                                 |  
|---------------------------------------------------------- |  |  | ----------------------------------------------------------- |  |  | --------------------------------------------------------------- | -
|                                                           |  |  | Number of
        shares
        beneficially
        owned |  |  | Percentage
        of shares
        beneficially
        owned |  
|                                                           |  |  |                                                             |  |  |                                                                 |  
|Jacob (Yanki) Margalit(1)                                  |  |  | 1,860,795                                                   |  |  | 13.3                                                            | %
|Dany Margalit(2)                                           |  |  | 891,695                                                     |  |  | 6.3                                                             | %
|Juniper Trading Services,
        Inc.(3)                  |  |  | 2,104,700                                                   |  |  | 14.4                                                            | %
|FMR Corp. (4)                                              |  |  | 2,152,300                                                   |  |  | 14.7                                                            | %
|Tracer Capital Management
        L.P. (5)                 |  |  | 1,002,015                                                   |  |  | 6.9                                                             | %
|Galleon Advisors, L.L.C. (6)                               |  |  | 1,641,740                                                   |  |  | 11.2                                                            | %
|Diker Management, LLC
        (7)                          |  |  | 977,265                                                     |  |  | 6.7                                                             | %
|All directors and executive officers as
        a group (7 |  |  |                                                             |  |  |                                                                 |  
|persons)(8)                                                |  |  | 2,753,490                                                   |  |  | 19.8                                                            | %

(1) Consists of 1,860,795 ordinary shares and
options to purchase 100,000 ordinary shares.


(2) Consists of 891,695 ordinary shares and
options to purchase 32,500 ordinary shares.


(3) Based on a Schedule 13D filed on
September 29, 2000, consists of 2,104,700 ordinary shares. The address of
Juniper Trading Services, Inc. is Compass Point Building, 9 Bermudiana Road,
Bermuda.


(4) Based on notification received by the
Company from Fidelity International on May 11, 2006. The beneficial ownership
above represents the aggregate beneficial ownership of FMR Corp. and Fidelity
International Limited, which we refer to together as Fidelity, parent companies
of various investment advisors that manage institutional accounts and open-end
investment companies managed by Fidelity. FMR Corp. is located at 82 Devonshire
Street, Boston, Massachusetts, and Fidelity International is located at P.O.
Box 670, Hamilton, HMCX, Bermuda.


(5)Based on a
Schedule 13G filed on February 15, 2006. The beneficial ownership
indicated above represents the aggregate beneficial ownership of Tracer Capital
Management L.P., Tracer Capital Partners, L.P., Tracer Capital Partners QP,
L.P. and Tracer Capital Offshore Fund Ltd. c/o Goldman Sachs (Cayman) Trust
Limited. Tracer Capital Management L.P. is located at 540 Madison Avenue, 33rd
Floor, New York, New York 10022, and is controlled by Riley McCormack and Matt
Hastings.


(6) Based on a Schedule 13G/A filed on
February 15, 2006. The beneficial ownership indicated above represents the
aggregate beneficial ownership of Galleon Advisors, L.L.C., Galleon Management,
L.L.C., Galleon Management, L.P., Galleon Captains Partners, L.P., Galleon
Captains Offshore, LTD., Galleon Technology Partners II, L.P., Galleon
Technology Offshore, LTD., Galleon Explorers Partners, L.P., Galleon Explorers
Offshore LTD. and Galleon Buccaneers Offshore, Ltd. Galleon Management, L.P.
is located at 135 East 57th Street, 16th Floor, New York,
New York, 10022 and is controlled by Raj Rajaratnam.


(7) Based on a Schedule 13G/A filed on
February 14, 2006. The beneficial ownership indicated above represents the
aggregate beneficial ownership of Diker Management LLC and Diker GP, LLC. Diker
Management, LLC is located at 745 Fifth Avenue, Suite 1409, New York, New York
10151, and is controlled by Charles M. Diker and Mark N. Diker.


(8) Consists of 2,753,490 ordinary shares and
options to purchase 177,325 ordinary shares.


To our
knowledge, the only significant change in the percentage ownership held by any
major beneficial shareholders during the past three years has been the change
in ownership of FMR Corp. In the past several months, FMR Corp has increased
their percentage ownership from approximately 10% to its current percentage
ownership of 14.7%.

The voting
rights of our major shareholders do not differ from the voting rights of other
holders of our ordinary shares.

As
  of June 27, 2006, there were a total of 59 holders of record of our issued and
  outstanding ordinary shares, of which 23 were registered with addresses in the
  United States. Such United States holders were, as of such date, the holders
  of record of approximately 82% of our issued and outstanding ordinary shares.
  The number of record holders in the United States is not representative of the
  number of beneficial holders, nor is it representative of where such beneficial
  holders are resident because many of these ordinary shares were held of record
  by brokers or other nominees.

B. RELATED
PARTY TRANSACTIONS

DIRECTORS FEES

We
pay directors fees in respect of service by our non-executive directors. See
Item 6B Directors, Senior Management and Employees  Compensation.

40

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AGREEMENTS WITH DIRECTORS AND OFFICERS

Employment agreements

We
maintain written employment agreements with all of our officers. For
compensation information regarding our officers, see ManagementCompensation.

Indemnification and insurance

We
have entered into agreements with each of our officers and directors
undertaking to exculpate and indemnify them to the fullest extent permitted by
our articles of association. This indemnification is limited to events and
amounts determined as foreseeable by the board of directors. In the opinion of
the Securities and Exchange Commission such indemnification of directors and
officers for liabilities arising under the Securities Act is against public
policy as expressed in the Securities Act and is therefore unenforceable.

Our
directors and officers are currently covered by a directors and officers
liability insurance policy. To date, no claims for liability have been filed
under this policy.

Loan agreements

In
2000, we entered into loan agreements with several of our officers pursuant to
which we loaned such officers an aggregate amount of $1.15 million for the
purpose of enabling them to invest in Tamir Fishman Venture Capital II Ltd. The
loans were linked to the Israel consumer price index and were interest-bearing
at a rate of 4% per year. These loan programs were cancelled in January 2002.
Our employees (and former employees) transferred their shares in Tamir Fishman
Venture Capital II Ltd. to us in return for the waiver of the commitment of the
employees regarding the loans granted to them by us. In addition, in 2000,
Aladdin Knowledge Systems, Inc. loaned its employees $124,000. This amount
includes money loaned to our employees who have since left the company. We are
currently in the process of finalizing similar arrangements for the employees
of our U.S. subsidiary whereby the loans are cancelled and their shares in
Tamir Fishman Ventures II LP will be transferred to us.

C. INTERESTS OF
EXPERTS AND COUNSEL

Not
applicable.

Item 8. Financial Information.

A. CONSOLIDATED
STATEMENTS AND OTHER FINANCIAL INFORMATION

Our
consolidated financial statements are included in this annual report in Item
18: Financial Statements.

Legal Proceedings

We
and our subsidiary, Aladdin Knowledge Systems Inc., were named as defendants in
a complaint filed on May 19, 2004, by Andrew Pickholtz in the U.S.
District Court for the Northern District of California alleging that our MicroGuard
product, which is discontinued, and certain of our software DRM products,
infringed a now-expired patent. By an amended complaint, an affiliate of
Rainbow Technologies, the holder of the patent, was added as a plaintiff. In
April 2005, we reached a settlement with respect to this claim pursuant to
which we made a one-time payment of $2 million to the plaintiffs in exchange
for a full release of all claims.

We
asserted claims in the United States District Court for the District of
Delaware against a Chinese entity, Feitian Technologies Co., Ltd., and a number
of other entities who we allege act as U.S. distributors for Feitian and who,
with or through Feitian, import, distribute, sell and offer for sale certain
products that we believe infringe on two of our U.S. patents. One of the
defendants entered into a settlement agreement with us in which it acknowledged
the validity and enforceability of the patents, acknowledged that certain
products manufactured or distributed by Feitian infringe upon those patents,
and agreed to cease to import, distribute, sell, or offer to sell in or into
the United States any products that infringe upon the patents. Feitian and
several other defendants moved to

41

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dismiss the
case on the basis that the federal court in Delaware did not have jurisdiction
over them. The court granted the motion as to certain defendants and dismissed
the case against them without prejudice. The court denied the motion as to
Feitian and another defendant, RS-Computer. The court is allowing us to take
discovery to support our claim that the federal court in Delaware has
jurisdiction over Feitian and RS-Computer. Once we have completed our discovery
we will file a supplemental brief on the jurisdictional issues with the court
and either Feitian or RS-Computer may re-assert their motions to dismiss. We
intend to vigorously pursue our claims whether we remain in the federal court
in Delaware or file suit in another U.S. court. At this time we cannot predict
the outcome of the case.

We
are not a party to any other material litigation or proceeding and are not
aware of any other material litigation or proceeding, pending or threatened, to
which we may become a party.

Dividend policy

We
currently intend to retain all earnings to support our operations and to
finance the growth and development of our business, and have no current
intentions to declare or pay any cash dividends on our ordinary shares. We are
not subject to any contractual restrictions on paying dividends. Any future
determination relating to our dividend policy will be made at the discretion of
our board of directors and will depend on a number of factors, including our
future earnings, capital requirements, financial condition, future prospects
and other factors as the board of directors may deem relevant. Israeli law
limits the distribution of cash dividends to the greater of retained earnings
or earnings generated over the two most recent years, in either case provided
that we reasonably believe that the dividend will not render us unable to meet
our current or foreseeable obligations when due.

B. SIGNIFICANT
CHANGES

Except
as otherwise disclosed in this annual report, there has been no material change
in our financial position since December 31, 2005.

|                               | 
|------------------------------ | 
|Item 9. The Offer and Listing.

A. OFFER AND
LISTING DETAILS

On
June 26, 2006, the last reported sale price of our ordinary shares on The
Nasdaq National Market was $19.15 per share. The table below sets forth the
high and low closing sales prices of our ordinary shares, as reported by The
Nasdaq National Market during the periods indicated:

| |                                                     |  |      |       |     |   |       | 
| | --------------------------------------------------- |  | ---- | ----- | --- | - | ----- | 
| |                                                     |  | High |       | Low |  
| |                                                     |  |      |       |     |  
| | Annual                                              |  |      |       |     |   |       | 
| | 2006 (through June 26, 2006)                        |  | $    | 23.57 |     | $ | 16.81 | 
| | 2005                                                |  |      | 25.40 |     |   | 15.95 | 
| | 2004                                                |  |      | 32.12 |     |   | 8.73  | 
| | 2003                                                |  |      | 10.10 |     |   | 2.25  | 
| | 2002                                                |  |      | 3.86  |     |   | 0.85  | 
| | 2001                                                |  |      | 5.91  |     |   | 2.43  | 
| | Quarterly                                           |  |      |       |     |   |       | 
| | Second Quarter 2006 (through
        June 26, 2006) |  | $    | 23.57 |     | $ | 19.15 | 
| | First Quarter 2006                                  |  |      | 22.49 |     |   | 16.81 | 
| | Fourth Quarter 2005                                 |  |      | 21.29 |     |   | 15.95 | 
| | Third Quarter 2005                                  |  |      | 22.21 |     |   | 18.45 | 
| | Second Quarter 2005                                 |  |      | 24.36 |     |   | 19.91 | 
| | First Quarter 2005                                  |  |      | 25.40 |     |   | 19.60 | 
| | Fourth Quarter 2004                                 |  |      | 32.12 |     |   | 21.57 | 
| | Third Quarter 2004                                  |  |      | 28.75 |     |   | 13.00 | 
| | Second Quarter 2004                                 |  |      | 25.75 |     |   | 16.21 | 
| | First Quarter 2004                                  |  |      | 19.80 |     |   | 8.73  | 
| | Most Recent Six
        Months                      |  |      |       |     |   |       | 
| | June 2006 (through June 26, 2006)                   |  | $    | 22.37 |     | $ | 19.15 | 

42

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| |                 |  |  |       |  |  |       | 
| | --------------- |  |  | ----- |  |  | ----- | 
| | May 2006        |  |  | 20.76 |  |  | 23.57 | 
| | April 2006      |  |  | 23.45 |  |  | 21.35 | 
| | March 2006      |  |  | 22.49 |  |  | 19.33 | 
| | February
  2006 |  |  | 19.93 |  |  | 17.40 | 
| | January 2006    |  |  | 18.38 |  |  | 16.81 | 
| | December
  2005 |  |  | 17.38 |  |  | 16.25 | 

The
following table sets forth, for the periods indicated, the high and low closing
sales prices of our ordinary shares on the Tel Aviv Stock Exchange:

| |                                                     |  |  |            |  |  |           | 
| | --------------------------------------------------- |  |  | ---------- |  |  | --------- | 
| |                                                     |  |  | High       |  |  | Low       | 
| |                                                     |  |  |            |  | 
| | Annual                                              |  |  |            |  |  |           | 
| | 2006 (through June 26, 2006)                        |  |  | NIS 108.30 |  |  | NIS 77.51 | 
| | 2005                                                |  |  | 112.40     |  |  | 73.88     | 
| | Quarterly                                           |  |  |            |  |  |           | 
| | Second Quarter 2006 (through
        June 26, 2006) |  |  | 108.30     |  |  | 86.44     | 
| | First Quarter 2006                                  |  |  | 103.90     |  |  | 77.51     | 
| | Fourth Quarter 2005                                 |  |  | 95.63      |  |  | 73.88     | 
| | Third Quarter 2005                                  |  |  | 100.70     |  |  | 83.55     | 
| | Second Quarter 2005                                 |  |  | 105.90     |  |  | 88.24     | 
| | First Quarter 2005                                  |  |  | 112.40     |  |  | 85.66     | 
| | Fourth Quarter 2004                                 |  |  | 137.80     |  |  | 99.58     | 
| | Third Quarter 2004                                  |  |  | 102.30     |  |  | 69.47     | 
| | Most Recent Six
        Months                      |  |  |            |  |  |           | 
| | June 2006 (through June 26, 2006)                   |  |  | NIS 99.20  |  |  | NIS 86.44 | 
| | May 2006                                            |  |  | 104.70     |  |  | 93.41     | 
| | April 2006                                          |  |  | 108.30     |  |  | 100.40    | 
| | March 2006                                          |  |  | 103.90     |  |  | 89.77     | 
| | February 2006                                       |  |  | 95.30      |  |  | 79.98     | 
| | January 2006                                        |  |  | 85.79      |  |  | 77.51     | 
| | December 2005                                       |  |  | 80.12      |  |  | 75.07     | 

43

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As
of June 26, 2006, the exchange rate of the NIS to the U.S. dollar was $1=NIS
4.47.

B.
PLAN OF DISTRIBUTION

Not
applicable.

C. MARKETS

The
primary trading market for our
ordinary shares is The Nasdaq National Market, where our shares are listed
under the symbol ALDN. Since July 28, 2004, our ordinary shares have also
been listed on the Tel Aviv Stock Exchange under the symbol ALDN.

D.
SELLING SHAREHOLDERS

Not
applicable.

E.
DILUTION

Not
applicable.

F.
EXPENSES OF THE ISSUE

Not
applicable.

Item 10.
Additional Information.

A.
SHARE CAPITAL

Not
applicable.

B.
MEMORANDUM AND ARTICLES OF ASSOCIATION

Approval of certain transactions
under the Companies Law

The
Companies Law codifies the fiduciary duties that office holders, including
directors and executive officers, owe to a company. An office holders
fiduciary duties consist of a duty of care and a duty of loyalty. The duty of loyalty
includes (i) avoiding any conflict of interest between the office holders
position in the company and his personal affairs, (ii) avoiding any competition
with the company, (iii) avoiding exploiting any business opportunity of the
company in order to receive personal advantage for himself or others and (iv)
revealing to the company any information or documents relating to the companys
affairs which the office holder has received due to his position as an office
holder. Each person listed in the table in item 6 under Directors and Senior
Management above is an office holder. Under the Companies Law, arrangements
regarding the compensation of directors require the approval of the audit
committee, the board of directors and shareholders.

The
Companies Law requires that an office holder of a company promptly disclose any
personal interest that he or she may have and all related material information
known to him or her, in connection with any existing or proposed transaction by
the company. In addition, if the transaction is an extraordinary transaction
as defined under the Companies Law, the office holder must also disclose any
personal interest held by the office holders spouse, siblings, parents,
grandparents, descendants, spouses descendants and the spouses of any of the
foregoing. In addition, the office holder must also disclose any interest held
by any corporation in which the office holder owns 5% or more of the share
capital, is a director or general manager or in which he or she has the right
to appoint at least one director or the general manager. An extraordinary
transaction is defined as a transaction other than in the ordinary course of
business, otherwise than on market terms or that is likely to have a material
impact on the companys profitability, assets or liabilities.

44

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Under
the Companies Law, after the office holder complies with the disclosure
requirements described above, only board approval is required for any
transaction which is not an extraordinary transaction, unless the articles of
association of the company provide otherwise, and provided the transaction is
not adverse to the companys interest. If the transaction is an extraordinary
transaction, the company must receive any approval stipulated by its articles
of association, the approval of the audit committee and the approval of the
board of directors, as well as shareholder approval. An office holder who has a
personal interest in a matter that is considered at a meeting of the board of
directors or the audit committee may not be present at this meeting or vote on
this matter unless the majority of the board members or members of the audit
committee, as applicable, have a personal interest in such matter and in such
case, the matter should also be approved by the shareholders of the company.

The
Companies Law applies the same disclosure requirements to a controlling
shareholder of a public company, including a shareholder that holds 25% or more
of the voting rights in the company if no other shareholder owns more than 50%
of the voting rights in the company. Extraordinary transactions with a
controlling shareholder or in which a controlling shareholder has a personal
interest, and the terms of compensation of a controlling shareholder or its
relative who is an office holder or an employee of the company, require the
approval of the audit committee, the board of directors and the shareholders of
the company. The shareholder approval must include at least one-third of the
shareholders who have no personal interest in the transaction and are voting on
the subject matter or, alternatively, the total shareholdings of those who have
no personal interest in the transaction who vote against the transaction must
not represent more than one percent of the voting rights in the company. In
certain cases provided in regulations promulgated under the Companies Law,
shareholder approval is not required.

The
approvals of the board of directors and shareholders are required for a private
placement of securities (or a series of related private placements during a
12-month period or that are part of one continuous transaction or transactions
conditioned upon each other) in which:

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                         
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | the securities issued represent at least 20% of the
  companys actual voting power prior to the issuance of such securities, and
  such issuance increases the relative holdings of a 5% shareholder or causes
  any person to become a 5% shareholder, and the consideration in the
  transaction (or a portion thereof) is not in cash or in securities listed on
  a recognized stock exchange, or is not at a fair market value; or
| | a person would become, as a result of such
  transaction, a controlling shareholder of the company.                                                                                                                                                                                                                                                                                                                                     

Under
the Companies Law, a shareholder has a duty to act in good faith towards the
company and other shareholders and to refrain from abusing his power in the
company including, among other things, voting in a general meeting of
shareholders on the following matters:

|  |                                                                               
|- | ------------------------------------------------------------------------------
| | any amendment to the articles of association;                                 
| | an increase of the companys authorized share
  capital;                      
| | a merger; or                                                                  
| | approval of interested party transactions that
  require shareholder approval.

In
addition, any controlling shareholder, any shareholder who knowingly possesses
power to determine the outcome of a shareholder vote and any shareholder who,
pursuant to the provisions of a companys articles of association, has the
power to appoint or prevent the appointment of an office holder in the company,
is under a duty to act with fairness towards the company. The Companies Law
does not describe the substance of this duty.

For
information concerning personal interests of certain of our office holders and
our principal shareholders in certain transactions with us, see Item 7.B.
Related Party Transactions.

Our
Articles of Association

We
have currently outstanding only one class of securities, our ordinary shares,
par value NIS 0.01 per share. No preferred shares are currently authorized.

Holders
of ordinary shares have one vote per share, and are entitled to participate
equally in the payment of dividends and share distributions and, in the event
of our liquidation, in the distribution of assets after satisfaction of

45

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liabilities to creditors. Our Articles of Association
may be amended by a resolution carried at a general meeting by an ordinary
majority (50%) of those who voted on the matter. The shareholders rights may
not be modified in any other way unless otherwise expressly provided in the
terms of issuance of the shares.

Our
Articles of Association require that we hold our annual general meeting of
shareholders once every calendar year and in accordance with the timing
requirements set forth under Israeli law, at a time and place determined by the
board of directors, upon at least 21 days prior notice to our shareholders. No
business may be commenced until a quorum of two or more shareholders who hold
or represent between or among them at least 33 1/3% of the Companys issued share
capital are present in person or by proxy. If within a half hour from the time
appointed for the meeting a quorum is not present, the meeting, shall be
dissolved, but in any other case it shall stand adjourned for one week, to the
same day, time and place, without it being necessary to notify the shareholders
of such or such other time and place as specified in the notice or to such
later day and at such time and place as the chairman may determine with the
consent of an ordinary majority. If a quorum is not present at the adjourned
meeting within half an hour of the time fixed for the commencement thereof,
subject to the provisions of applicable law, the persons present shall
constitute a quorum. Shareholders may vote in person or by proxy, and will be
required to prove title to their shares as required by the Companies Law
pursuant to procedures established by the board of directors. Resolutions
regarding the following matters must be passed at a general meeting of
shareholders:

|  |                                                                                                                                                                                                                                  
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | amendments to our Articles of Association
        (other than modifications of shareholders rights as mentioned above);                                                                                                         
| | appointment or termination of our auditors;                                                                                                                                                                                      
| | appointment and dismissal of directors;                                                                                                                                                                                          
| | approval of acts and transactions requiring
        general meeting approval under the Companies Law;                                                                                                                            
| | increase or reduction of our authorized share
        capital or the rights of shareholders or a class of shareholders;                                                                                                          
| | any merger; and                                                                                                                                                                                                                  
| | the exercise of the board of directors
        powers by a general meeting, if the board of directors is unable to exercise
        its powers and the exercise of any of its powers is vital for our proper
        management.

A
special meeting of our shareholders shall be convened by the board, at the
request of any two directors or one quarter of the officiating directors, or by
request of one or more shareholders holding at least 5% of our issued share
capital and 1% of our voting rights, or by request of one or more shareholders
holding at least 5% of our voting rights. Shareholders requesting a special
meeting must submit their proposed resolution with their request. Within 21
days of receipt of the request, the board must convene a special meeting and
send out notices setting forth the date, time and place of the meeting. Such
notice must be given at least 21 days, but not more than 35 days, prior to the
special meeting.

Our
Articles of Association provide that our board of directors may from time to
time, at their discretion, borrow or secure the payment of any sum of money for
the objectives of the Company. Our directors may raise or secure the repayment
of such sum in a manner, time and terms as they see fit.

Exculpation,
insurance and indemnification of directors and officers

Under
the Companies Law, an Israeli company may not exempt an office holder from
liability with respect to a breach of his duty of loyalty, but may exempt in
advance an office holder from his liability to the company, in whole or in
part, with respect to a breach of his duty of care, provided, however, that
such a breach is not related to a distribution of a dividend or any other
distribution by the company.

46

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Office
holders insurance

Our
articles of association provide that the Company may insure an office holder
for any liability imposed on such office holder in connection with an act
performed in the office holders capacity as an office holder of the Company,
subject to the provisions of the Companies Law, with respect to each of the
following: (i) violation of the duty of care of the office holder towards the
Company or towards another person; (ii) breach of fiduciary duty towards the
Company provided that the office holder acted in good faith and with reasonable
grounds to assume that the action in question was in the best interests of the
Company; (iii) a financial obligation imposed on the office holder for the
benefit of another person and (iv) any other obligation or expense for which it
is or shall be permitted to insure and office holder.

The
foregoing shall not apply under any of the following circumstances: (i) a
breach of an office holders fiduciary duty, in which the office holder did not
act in good faith and with reasonable grounds to assume that the action in
question was in the best interest of the Company; (ii) a grossly negligent or
intentional violation of an office holders duty of care; (iii) an intentional
action by an office holder in which such office holder intended to reap a
personal gain illegally; and (iv) a fine or ransom levied on an office holder.

Indemnification
of office holders

Our
articles of association provide that the Company may indemnify, either
retroactively or in advance, any office holder to the fullest extent permitted
by the Companies Law.

The
Company may resolve retroactively to indemnify an office holder with respect to
the following liabilities and expenses, provided that such liabilities or
expenses were incurred by such office holder in such office holders capacity
as an office holder of the Company: (i) a monetary liability imposed on an
office holder pursuant to a judgment in favor of another person, including a
judgment imposed on such office holder in a compromise or in an arbitration
decision that was approved by a court of law; (ii) reasonable legal expenses,
including attorneys fees, which the office holder incurred or with which the
office holder was charged by a court of law, in a proceeding brought against
the office holder, by the Company or by another on behalf of the Company, or in
a criminal prosecution in which the office holder was acquitted, or in a
criminal prosecution in which the office holder was convicted of an offense
that does not require proof of criminal intent; and (iii) any other obligation
or expense for which it is or shall be permitted to indemnify an office holder.

The
Company may resolve in advance to indemnify the Companys office holders for
those same liabilities and expenses it may resolve retroactively to indemnify
an office holder, provided that (i) in the opinion of the Board of Directors
such liabilities and expenses can be foreseen at the time the undertaking to
indemnify is provided, and (ii) the Board of Directors shall set a reasonable
limit to the amounts for such indemnification under the circumstances.

The
foregoing shall not apply under any of the following circumstances: (i) a
breach of an office holders fiduciary duty, in which the office holder did not
act in good faith and with reasonable grounds to assume that the action in question
was in the best interest of the Company; (ii) a grossly negligent or
intentional violation of an office holders duty of care; (iii) an intentional
action by an office holder in which such office holder intended to reap a
personal gain illegally; and (iv) a fine or ransom levied on an office holder.

Limitations
on exemption, insurance and indemnification

The
Companies Law provides that a company may not indemnify an office holder,
neither enter into an insurance contract that would provide coverage for any
monetary liability, nor exempt an office holder from liability, with respect to
any of the following:

47

---



| |   |                                                                                                                                                                                                                                                                                  
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a breach by the office holder of his duty of
  loyalty, except that the company may indemnify or provide insurance coverage
  to the office holder if the office holder acted in good faith and had a
  reasonable basis to believe that the act would not prejudice the company;
| |  | a breach by the office holder of his duty of care if
  the breach was done intentionally or recklessly, except for a breach that was
  made in negligence;                                                                                                                       
| |  | any act or omission done with the intent to derive
  an illegal personal benefit; or                                                                                                                                                                                             
| |  | any fine levied against the office holder.                                                                                                                                                                                                                                       

In
addition, under the Companies Law, indemnification of, and procurement of
insurance coverage for, our office holders must be approved by our audit
committee and our board of directors and, in specified circumstances, by our
shareholders.

Anti-takeover
provisions; mergers and acquisitions under Israeli law

Mergers

The
Companies Law includes provisions that allow a merger transaction and requires
that each company that is party to a merger approve the transaction by its
board of directors and a vote of the majority of its shares voting on the
proposed merger at a shareholders meeting called on at least 21 days prior
notice. In determining whether a majority has approved the merger, shares held
by the other party to the merger or any person holding at least 25% of the
other party to the merger are excluded from the vote. The Companies Law does
not require court approval of a merger other than in specified situations. Upon
the request of a creditor of either party to the proposed merger, the court may
delay or prevent the merger if it concludes that there exists a reasonable
concern that as a result of the merger, the surviving company will be unable to
satisfy the obligations of any of the parties to the merger. In addition, a
merger may not be completed unless at least 30 days have passed since the
approval of the merger by the shareholders of each of the merging companies and
50 days have passed from the time that a proposal for approval of the merger
has been filed with the Israeli registrar of companies.

Tender
offers

The
Companies Law also provides that an acquisition of shares of a public company
on the open market must be made by means of a tender offer if as a result of
the acquisition the purchaser would become a 25% shareholder of the company.
The rule does not apply if there is already another 25% shareholder of the
company. Similarly, the Companies Law provides that an acquisition of shares in
a public company must be made by means of a tender offer if, as a result of the
acquisition, the purchaser would become a 45% shareholder, unless there is a 50%
shareholder of the company. These rules do not apply if the acquisition is made
by way of a merger as opposed to a tender offer. Regulations adopted under the
Companies Law provide that these tender offer requirements do not apply to
companies whose shares are listed for trading outside of Israel if, according
to the law in the country in which the shares are traded, including the rules
and regulations of the stock exchange on which the shares are traded, there is
either a limitation on acquisition of any level of control of the company, or
the acquisition of any level of control requires the purchaser to do so by
means of a tender offer to the public. The Companies Law also provides that if
following any acquisition of shares, the acquirer holds 90% or more of the
companys shares or of a class of shares, the acquisition must be made by means
of a tender offer for all the target companys shares or all the shares of the
class, as applicable. An acquirer who wishes to eliminate all minority
shareholders must do so by way of a tender offer and acquire 95% of all shares
not held by or for the benefit of the acquirer before the acquisition. If,
however, the tender offer to acquire 95% is not successful, the acquirer may
not acquire shares tendered if by doing so the acquirer would own more than 90%
of the shares of the target company.

C. MATERIAL CONTRACTS

None.

48

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D. EXCHANGE CONTROLS

Under
Israeli law and permits issued pursuant to the law, non-residents of Israel who
purchase ordinary shares with certain non-Israeli currencies (including
dollars) may freely repatriate in such non-Israeli currencies all amounts
received in Israeli currency in respect of the ordinary shares, whether as a
dividend, as a liquidating distribution, or as proceeds from any sale in Israel
of the ordinary shares, provided in each case that any applicable Israeli
income tax is paid or withheld on such amounts. The conversion into the
non-Israeli currency must be made at the rate of exchange prevailing at the
time of conversion.

Under
Israeli law, both residents and non-residents of Israel may freely hold, vote
and trade our ordinary shares.

E.
TAXATION

Israeli
Taxation

The
following is a description of material tax consequences regarding the ownership
and disposition of our ordinary shares under Israeli tax laws to which our
shareholders may be subject. The information below does not apply to specific
persons or cover specific situations. Therefore, you are advised to consult
your own tax advisor as to particular tax consequences unique to you related to
an investment in our ordinary shares including the effects of applicable
Israeli or foreign or other tax laws and possible changes in the tax laws.

To
the extent that the discussion is based on legislation yet to be judicially or
administratively interpreted, we cannot assure you that the views we express
herein will accord with any such interpretation in the future.

Tax Consequences Regarding Disposition of Our Ordinary
Shares

In
general, Israel imposes capital gains tax on the sale of capital assets,
including shares of Israeli companies by both Israeli residents and non-Israeli
resident shareholders, unless a specific exemption is available or unless a tax
treaty between Israel and the shareholders country of residence provide
otherwise. Shareholders that are not Israeli residents are generally exempt
from Israeli capital gains tax on any gain derived from the sale of our
ordinary shares, provided that (i) such shareholders did not acquire the shares
prior to our initial public offering; and (ii) such gains did not derive from a
permanent establishment of such shareholders in Israel. However, non-Israeli
corporations will not be entitled to the foregoing exemption if an Israeli
resident (a) has a controlling interest of 25% or more in such non-Israeli
corporation; or (b) is the beneficiary of or is entitled to 25% or more of the
revenues or profits of such non-Israeli corporation, whether directly or indirectly.

In
certain instances where our non-Israeli shareholders may be liable to Israeli
tax on the sale of our ordinary shares, the payment of the consideration may be
subject to Israeli withholding tax.

In
addition, the sale, exchange or disposition of our ordinary shares by
shareholders who are U.S. residents (within the meaning of the U.S.-Israel Tax
Treaty) holding the ordinary shares as a capital asset will be also exempt from
Israeli capital gains tax under the U.S.-Israel Tax Treaty, unless, either (i)
the shareholders hold, directly or indirectly, shares representing 10% or more
of our voting shares during any part of the 12-month period preceding such
sale, exchange or disposition; or (ii) the capital gains arising from such sale,
exchange or disposition are attributable to a permanent establishment of the
shareholders located in Israel. In such case, the shareholders would be subject
to Israeli capital gain tax, to the extent applicable, as mentioned above.
However, under the U.S.-Israel Tax Treaty, the U.S. resident would be permitted
to claim a credit for such taxes against the U.S. federal income tax imposed on
the sale, exchange or disposition, subject to the limitation in the U.S. law
applicable to foreign tax credits. The U.S.-Israel Tax Treaty does not relate
to U.S. state or local taxes.

Israeli
individual shareholders selling our ordinary shares are subject to 20% tax rate
on any real capital gain accrued after January 1, 2003, or 25% tax rate if such
individual shareholder holds more than 10% interest in the company. Israeli
corporate shareholders (which were not subject in 2005 to the provisions of the
Inflationary Adjustments Law), selling our ordinary shares are subject to a 25%
tax rate on any real capital gain. Israeli corporate

49

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shareholders which were
subject in 2005 to the provisions of the Inflationary Adjustments Law, selling
our ordinary shares are subject to the regular corporate tax rates on any
capital gain.

Taxes Applicable to Dividends

Non-residents
of Israel are generally subject to Israeli income tax on the receipt of
dividends paid on our ordinary shares at the rate of 20% or 15% for dividends
or income generated by an approved enterprise, which tax will be withheld at
source, unless a different rate is provided in a treaty between Israel and the
shareholders country of residence.

However,
the tax rate on dividends paid to a substantial shareholder (which is someone
who alone, or together with another person, holds, directly or indirectly, at
least 10% in one or all of any of the means of control in the corporation) is
25%.

Under
the U.S.-Israel Tax Treaty, the maximum rate of tax withheld in Israel on
dividends paid to a holder of our ordinary shares who is a U.S. resident
(within the meaning of the U.S.-Israel Tax Treaty) is 25%. However, dividends
paid from income derived from our Approved Enterprise are subject to
withholding at the rate of 15%, although we cannot assure you that we will
designate the profits that are being distributed in a way that will reduce
shareholders tax liability according to the U.S.-Israel Tax Treaty.
Furthermore, the maximum rate of withholding tax on dividends, not generated by
our Approved Enterprise, that are paid to a U.S. corporation holding 10% or
more of our outstanding voting capital during the part of the tax year that
precedes the date of the payment of the dividend and during the whole of its
prior tax year, is 12.5%. This reduced rate will not apply if more than 25% of
our gross income consists of interest or dividends, other than dividends or
interest received from a subsidiary corporation 50% or more of the outstanding
shares of the voting shares of which are owned by the company.

A
non-resident of Israel who receives dividends with respect of which tax was
fully paid, is generally exempt from the duty to file returns in Israel in
respect of such income, provided such income was not derived from a business
conducted in Israel by the taxpayer, and the taxpayer has no other taxable
sources of income in Israel.

U.S.
TAXATION

Subject
to the limitations described herein, the following is a discussion of the
material U.S. federal income tax consequences of the purchase, ownership and
disposition of our ordinary shares to a U.S. holder. A U.S. holder is a
beneficial owner of our ordinary shares who is:

|  |                                                                                                                                                                                                                                                                                                                                               
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a citizen or resident of the United States
        for U.S. federal income tax purposes;                                                                                                                                                                                                                                                      
| | a corporation or a partnership (or other entity
        taxable as a corporation or partnership for U.S. federal income tax purposes)
        created or organized under the laws of the United States or any political
        subdivision thereof;                                                                                          
| | an estate, the income of which is includible
        in gross income for U.S. federal income tax purposes regardless of its
        source; or                                                                                                                                                                                                
| | a trust (i) if a U.S. court is able to exercise
        primary supervision over its administration and one or more U.S. persons
        have the authority to control all of its substantial decisions or (ii)
        that has in effect a valid election under applicable U.S. Treasury regulations
        to be treated as a U.S. person.

A
non-U.S. holder is a beneficial owner of our ordinary shares that is not a U.S.
holder.

If
a partnership (or any other entity treated as a partnership for U.S. federal
income tax purposes) holds our ordinary shares, the tax treatment of the
partnership and a partner in such partnership will generally depend on the
status of the partner and the activities of the partnership. Such a partner or partnership
should consult its tax advisor as to its tax consequences.

50

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Unless
otherwise specifically indicated, this discussion does not consider the U.S.
tax consequences to a person that is a non-U.S. holder and considers only U.S.
holders that will own the ordinary shares as capital assets.

This
discussion is based on current provisions of the Internal Revenue Code of 1986,
as amended (the Code), current and proposed Treasury regulations promulgated
under the Code and administrative and judicial interpretations of the Code, all
as currently in effect and all of which are subject to change, possibly with a
retroactive effect. This discussion does not address all aspects of U.S.
federal income taxation that may be relevant to any particular U.S. holder
based on the U.S. holders particular circumstances. In particular, this
discussion does not address all U.S. federal income tax consequences to U.S.
holders who are broker-dealers or who own, directly, indirectly or
constructively, 10% or more of our outstanding shares (by vote or value), real
estate investment trusts, grantor trusts, U.S. holders holding the ordinary
shares as part of a hedging, straddle or conversion transaction, U.S. holders
whose functional currency is not the U.S. dollar, insurance companies,
tax-exempt organizations, financial institutions, persons who are, or hold the
ordinary shares through a partnership or other pass-through entity and persons
subject to the alternative minimum tax, who may be subject to special rules not
discussed below. Additionally, this discussion does not address the possible
application of U.S. federal estate or gift taxes or any aspect of state, local
or non-U.S. tax laws.

Each
holder of our ordinary shares is advised to consult his or her tax advisor with
respect to the specific U.S. federal, state, local and foreign income tax
consequences to him or her of purchasing, holding or disposing of our ordinary
shares.

U.S. Holders of Ordinary Shares

Taxation
of distributions on ordinary shares

Subject
to the discussion below under Tax Consequences if we are a passive foreign
investment company, a distribution paid by us with respect to our ordinary
shares to a U.S. holder will be treated as dividend income to the extent that the
distribution does not exceed our current and accumulated earnings and profits,
as determined for U.S. federal income tax purposes. The amount of a
distribution with respect to the ordinary shares will equal the amount of cash
and the fair market value of any property distributed and will also include the
amount of any Israeli taxes withheld as described under Israeli Taxation and
Government ProgramsWithholding on Dividends Paid to Non-Residents of Israel.
Subject to the discussion below under Tax Consequences if we are a passive
foreign investment company, dividends that are received through the taxable
year ending December 31, 2008 by U.S. holders that are individuals, estates or
trusts generally will be taxed at the rate applicable to long-term capital
gains (a maximum rate of 15%), provided that such dividends meet the
requirements of qualified dividend income. Dividends that fail to meet such
requirements, and dividends received by corporate U.S. holders, are taxed at
ordinary income rates. No dividend received by a U.S. holder will be a
qualified dividend (1) if the U.S. holder held the ordinary share with respect
to which the dividend was paid for less than 61 days during the 121-day period
beginning on the date that is 60 days before the ex-dividend date with respect
to such dividend, excluding for this purpose, under the rules of Code section
246(c), any period during which the U.S. holder has an option to sell, is under
a contractual obligation to sell, has made and not closed a short sale of, is
the grantor of a deep-in-the-money or otherwise nonqualified option to buy, or
has otherwise diminished its risk of loss by holding other positions with
respect to, such ordinary share (or substantially identical securities); or (2)
to the extent that the U.S. holder is under an obligation (pursuant to a short
sale or otherwise) to make related payments with respect to positions in
property substantially similar or related to the ordinary share with respect to
which the dividend is paid. If we were to be a passive foreign investment
company (as such term is defined in the Code) for any year, dividends paid on
our ordinary shares in such year or in the following year would not be
qualified dividends. In addition, a non-corporate U.S. holder will be able to
take a qualified dividend into account in determining its deductible investment
interest (which is generally limited to its net investment income) only if it
elects to do so; in such case the dividend will be taxed at ordinary income
rates.

The
amount of any distribution which exceeds the amount treated as a dividend will
be treated first as a non-taxable return of capital, reducing the U.S. holders
tax basis in its ordinary shares to the extent thereof, and then as capital
gain from the deemed disposition of the ordinary shares. Corporate holders will
not be allowed a deduction for dividends received in respect of the ordinary
shares.

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Dividends
paid by us in NIS will be included in the gross income of U.S. holders at the
dollar amount of the dividend (including any Israeli taxes withheld therefrom),
based upon the spot rate of exchange in effect on the date the distribution is
included in income. U.S. holders will have a tax basis in the NIS for U.S.
federal income tax purposes equal to that dollar value. Any subsequent gain or
loss in respect of the NIS arising from exchange rate fluctuations will
generally be taxable as U.S. source ordinary income or loss.

Subject
to the limitations set forth in the Code and the Treasury regulations
thereunder, U.S. holders may elect to claim as a foreign tax credit against
their U.S. federal income tax liability the Israeli income tax withheld from
dividends received in respect of the ordinary shares. The limitations on
claiming a foreign tax credit include, among others, computation rules under
which foreign tax credits allowable with respect to specific classes of income
cannot exceed the U.S. federal income taxes otherwise payable with respect to
each such class of income. In this regard, dividends paid by us will be foreign
source passive income for U.S. foreign tax credit purposes or, in the case of
a financial services entity, financial services income (and, for tax years
beginning after December 31, 2006, as general category income). U.S. holders
that do not elect to claim a foreign tax credit may instead claim a deduction
for the Israeli income tax withheld if they itemize deductions. The rules
relating to foreign tax credits are complex, and you should consult your tax
advisor to determine whether and to what extent you would be entitled to this
credit. A U.S. holder will be denied a foreign tax credit for Israeli income
tax withheld from a dividend received on the ordinary shares (i) if the U.S.
holder has not held the ordinary shares for at least 16 days of the 31-day
period beginning on the date which is 15 days before the ex-dividend date with
respect to such dividend or (ii) to the extent the U.S. holder is under an
obligation to make related payments with respect to positions in substantially
similar or related property. Any days during which a U.S. holder has
substantially diminished its risk of loss on the ordinary shares are not
counted toward meeting the required 16-day holding period. Distributions of
current or accumulated earnings and profits will be foreign source passive
income for U.S. foreign tax credit purposes.

Taxation
of the disposition of ordinary shares

Subject
to the discussion below under Tax Consequences if we are a passive foreign investment
company, upon the sale, exchange or other disposition of our ordinary shares,
a U.S. holder will recognize capital gain or loss in an amount equal to the
difference between the amount realized on the disposition and the U.S. holders
tax basis in the ordinary shares. The gain or loss recognized on the
disposition of the ordinary shares will be long-term capital gain or loss if
the U.S. holder held the ordinary shares for more than one year at the time of
the disposition. Capital gain from the sale, exchange or other disposition of
ordinary shares held for one year or less is short-term capital gain. Gain or
loss recognized by a U.S. holder on a sale, exchange or other disposition of
ordinary shares will be treated as U.S. source income or loss for U.S. foreign
tax credit purposes.

A
U.S. holder that uses the cash method of accounting calculates the dollar value
of the proceeds received on the sale as of the date that the sale settles.
However, a U.S. holder that uses the accrual method of accounting is required
to calculate the value of the proceeds of the sale as of the trade date and may
therefore realize foreign currency gain or loss. A U.S. holder may avoid
realizing foreign currency gain or loss by electing to use the settlement date to
determine the proceeds of sale for purposes of calculating the foreign currency
gain or loss. In addition, a U.S. holder that receives foreign currency upon
disposition of ordinary shares and converts the foreign currency into dollars
after the settlement date or trade date (whichever date the U.S. holder is
required to use to calculate the value of the proceeds of sale) will have
foreign exchange gain or loss based on any appreciation or depreciation in the
value of the foreign currency against the dollar.

Tax
consequences if we are a passive foreign investment company

We
will be a passive foreign investment company, or PFIC, for a taxable year if
either (1) 75% or more of our gross income in a taxable year is passive income;
or (2) 50% or more of the value, determined on the basis of a quarterly
average, of our assets in the taxable year produce, or are held for the
production of, passive income. If we own (directly or indirectly) at least 25%
by value of the stock of another corporation, we will be treated for purposes
of the foregoing tests as owning our proportionate share of the other
corporations assets and as directly earning our proportionate share of the
other corporations income. Passive income for this purpose generally includes dividends,
interest, royalties, rents and gains from commodities and securities
transactions.

52

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We
believe that we were not a PFIC for our 2005 taxable year. Our status in the
current and future years will depend on our assets and income in those years.
We have no reason to believe that our assets or income will change in a manner
that would cause us to be classified as a PFIC. However, since the
determination of whether we are a PFIC is based upon such factual matters as
the valuation of our assets (which may depend upon our market capitalization,
which is subject to fluctuation) and, in certain cases, the assets of companies
held by us, there can be no assurance that we will not become a PFIC. If we
were a PFIC, and you are a U.S. holder, you generally would be subject to
imputed interest charges and other disadvantageous tax treatment with respect
to any gain from the sale or exchange of, and certain distributions with
respect to, your ordinary shares (including the denial of the taxation of such
distributions and gains at the lower rates applicable to long-term capital
gains as discussed above under Taxation of distributions on ordinary shares
and Taxation of the disposition of ordinary shares).

If
we were a PFIC, you could make a variety of elections that may alleviate
certain tax consequences referred to above, and one of these elections may be
made retroactively if certain conditions are satisfied. It is expected that the
conditions necessary for making certain of such elections will apply in the
case of our ordinary shares. We will notify U.S. holders in the event we
conclude that we will be treated as a PFIC for any taxable year.

U.S.
holders are urged to consult their tax advisors regarding the application of
the PFIC rules, including eligibility for and the manner and advisability of
making certain elections with respect to our PFIC status.

Information
reporting and backup withholding

A
U.S. holder generally is subject to information reporting and may be subject to
backup withholding at a rate of 28% with respect to dividend payments made
within the United States or by a U.S. payor or U.S. middleman and receipt of
the proceeds from the disposition of the ordinary shares. Backup withholding
will not apply with respect to payments made within the United States or by a
U.S. payor or U.S. middleman to exempt recipients, including corporations, or
if a U.S. holder provides a correct taxpayer identification number, certifies
that such holder is not subject to backup withholding or otherwise establishes
an exemption. Backup withholding is not an additional tax. It may be claimed as
a credit against the U.S. federal income tax liability of a U.S. holder or the
U.S. holder may be eligible for a refund of any excess amounts withheld under
the backup withholding rules provided, in either case, that the required
information is furnished to the Internal Revenue Service.

Non-U.S. Holders of Ordinary Shares

Except
as provided below, a non-U.S. holder of ordinary shares (except certain former
U.S. citizens and long-term residents of the United States) will not be subject
to U.S. federal income or withholding tax on the receipt of dividends on, and
the proceeds from the disposition of, an ordinary share, unless that item is
effectively connected with the conduct by the non-U.S. holder of a trade or
business in the United States and, in the case of a resident of a country which
has an income tax treaty with the United States, that item is attributable to a
permanent establishment in the United States or, in the case of an individual,
a fixed place of business in the United States. In addition, gain recognized by
an individual non-U.S. holder will be subject to tax in the United States if
the non-U.S. holder is present in the United States for 183 days or more in the
taxable year of the sale and other conditions are met.

Non-U.S.
holders will not be subject to information reporting or backup withholding with
respect to the payment of dividends on ordinary shares unless the payment is
made within the United States or by a U.S. payor or U.S. middleman. Non-U.S.
holders will be subject to information reporting and backup withholding at a
rate of 28% with respect to the payment within the United States or by a U.S.
payor or U.S. middleman of dividends on the ordinary shares unless the holder
provides its taxpayer identification number, certifies to its foreign status or
otherwise establishes an exemption.

Non-U.S.
holders will be subject to information reporting and backup withholding at a
rate of 28% on the receipt of the proceeds from the disposition of the ordinary
shares to, or through, the United States office of a broker, whether domestic
or foreign, unless the holder provides a taxpayer identification number,
certifies to its foreign status or otherwise establishes an exemption. Non-U.S.
holders will not be subject to information reporting or backup withholding with
respect to the receipt of proceeds from the disposition of the ordinary shares
by a foreign office of a broker; provided, however, that if the broker is a
U.S. person or a U.S. related person, information reporting (but not backup
withholding) will apply unless the broker has documentary evidence in its

53

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records of the
non-U.S. holders foreign status or the non-U.S. holder certifies to its
foreign status under penalties of perjury or otherwise establishes an
exemption. For this purpose, a U.S. related person is a broker or other
intermediary that maintains one or more enumerated U.S. relationships. Backup
withholding is not an additional tax and may be claimed as a credit against the
U.S. federal income tax liability of a non-U.S. holder, or alternatively, the
non-U.S. holder may be eligible for a refund of any excess amounts withheld
under the backup withholding rules, in either case, provided that the required
information is furnished to the Internal Revenue Service.

F. DIVIDENDS AND PAYING AGENTS

Not
applicable.

G. STATEMENTS BY EXPERTS

Not
applicable.

H. DOCUMENTS ON DISPLAY

We
are required to file reports and other information with the SEC under the
Securities Exchange Act of 1934 and the regulations thereunder applicable to
foreign private issuers. Reports and other information filed by us with the SEC
may be inspected and copied at the SECs public reference facilities described
below. Although as a foreign private issuer we are not required to file
periodic information as frequently or as promptly as United States companies,
we generally do publicly announce our quarterly and year-end results promptly
and file periodic information with the SEC under cover of Form 6-K. As a
foreign private issuer, we are also exempt from the rules under the Exchange Act
prescribing the furnishing and content of proxy statements and our officers,
directors and principal shareholders are exempt from the reporting and other
provisions in Section 16 of the Exchange Act.

You
may review a copy of our filings with the SEC, including any exhibits and
schedules, at the SECs public reference facilities in Room 1024, Judiciary
Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549 and at the regional
offices of the SEC located at the Northwestern Atrium Center, 500 West Madison
Street, Suite 1400, Chicago, Illinois 60661. You may also obtain copies of such
materials from the Public Reference Section of the SEC, Room 1024, Judiciary
Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed rates. You
may call the SEC at 1-800-SEC-0330 for further information on the public
reference rooms. In addition, such information concerning our company can be
inspected and copied at the offices of the National Association of Securities
Dealers, Inc., 9513 Key West Avenue, Rockville, Maryland 20850 and at the
offices of the Israel Securities Authority at 22 Kanfei Nesharim St.,
Jerusalem, Israel. As a foreign private issuer, all documents which were filed
after November 4, 2002 on the SECs EDGAR system will be available for retrieval
on the SECs website at www.sec.gov. You may read and copy any reports,
statements or other information that we file with the SEC at the SEC facilities
listed above. These SEC filings are also available to the public from
commercial document retrieval services. We also generally make available on our
own web site all our quarterly and year-end financial statements as well as
other information.

Any
statement in this annual report about any of our contracts or other documents
is not necessarily complete. If the contract or document is filed as an exhibit
to the registration statement, the contract or document is deemed to modify the
description contained in this annual report. We urge you to review the exhibits
themselves for a complete description of the contract or document.

I. SUBSIDIARY INFORMATION

Not
applicable.

|                                                                     | 
|-------------------------------------------------------------------- | 
|Item 11. Quantitative and Qualitative Disclosures About Market Risk.

Market
risk is the risk of losses related to changes in market prices and foreign
exchange rates, that may adversely impact our consolidated financial position,
results of operations or cash flows.

54

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Foreign exchange risk

Although
we report our consolidated financial statements in U.S. dollars, in 2005 a
portion of our revenues and expenses was denominated, in other currencies. We
derived approximately 45% of revenues in U.S. dollars, 38% in Euros, 11% in
Japanese Yen and 6% in British pounds. In 2005, 79% of our expenses was
denominated in U.S. dollars, 11% in Euros, 5% in Japanese Yen and 5% in British
pounds.

Exchange
differences upon translation from the functional currency of our German
subsidiary, which is the Euro, to U.S. dollars are accumulated as a separate
component of accumulated other comprehensive loss under shareholders equity.
As of December 31, 2005, accumulated other comprehensive loss increased by
$492,000 compared to December 31, 2004. As of December 31, 2004,
accumulated other comprehensive loss decreased by $85,000 compared to December
31, 2003. Exchange differences upon translation from the functional currency
from our other selling and marketing subsidiaries (other than our U.S.
subsidiary) to U.S. dollars are reflected in our income statement under
financial income net.

We
have entered into foreign currency forward contracts and forward exchange
options generally of less than one year duration to hedge a portion of our
foreign currency risk on sales transactions and on non-U.S. dollar monetary
items. The objective of these transactions is to hedge cash flow in U.S.
dollars and non-U.S. dollar monetary items against fluctuations in the exchange
rates of the Euro, British pound and the Japanese Yen. As of December 31,
2005, we held one Euro forward contract with nominal amounts of 530,000 Euros,
one Euro forward exchange option with a nominal amount of 250,000 Euros, one
British pound forward contract with a nominal amount of 430,000 British pounds,
two Japanese Yen forward contracts with nominal amounts of 59 million Japanese
Yen, two Japanese Yen forward contracts with nominal amounts of 170 million
Japanese Yen and one New Israeli Shekel forward contract with a nominal amount
of NIS 6 million.

Equity Investments

We
hold equity investments in two companies whose securities are traded on the Tel
Aviv Stock Exchange, Tamir Fishman Venture Capital II Ltd. and Comsec
Information Security Ltd. As of December 31, 2005, the combined fair
market value of these investments was $1.4 million. The value of these holdings
has fluctuated and the fair market value at December 31, 2004 was $1.6
million.

As
of December 31, 2005, we had invested approximately $7.2 million in two
related private investment funds managed by Tamir Fishman
Ventures Management II Ltd. Each of these funds invests primarily in the
securities of privately-held technology companies in Israel. In 2002, we
realized an impairment charge of $1.0 million related to these investments and
we may realize additional impairment charges in the future. We have committed
to invest an additional $1.3 million in these entities prior to 2007. In March
2005, a fund managed by Tamir Fishman Ventures Management II Ltd. concluded the
sale of two of its portfolio companies. We have been advised that we will
receive a distribution of approximately $3 million (of which approximately
$970,000 will be in cash and the remainder in Common Stock of Agere Systems,
Inc.) as a result of these transactions. Approximately 15 percent of the
distribution will be held in escrow for approximately one year to cover
potential obligations of the portfolio companies to the buyers. In April 2005,
the Company received an amount of $ 910,000 in cash, out of the total
distribution.

Interest rate risk

Our
investments consist primarily of cash and cash equivalents, consisting of
short-term bank deposits with maturities of up to three months. In October 2004
and July 2005, the Company invested in U.S. government bonds with maturities of
up to four and two years, respectively.

Due
to the short and medium-term maturities of these investments, their carrying
value equals the fair value.

55

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|                                                                 | 
|---------------------------------------------------------------- | 
|Item 12.Descriptions of Securities Other than Equity Securities.

Not
Applicable.

PART II.

|                                                         | 
|-------------------------------------------------------- | 
|Item 13.Defaults, Dividend Arrearages and Delinquencies.

None.

|                                                                                       | 
|-------------------------------------------------------------------------------------- | 
|Item 14.Material Modifications to the Rights of Security Holders and Use of
  Proceeds

None.

|                                  | 
|--------------------------------- | 
|Item 15. Controls and
Procedures.

Our
chief executive officer and chief financial officer, after evaluating the
effectiveness of our disclosure controls and procedures (as defined in Rule
13a-15(e) of the Securities Exchange Act of 1934, as amended) as of
December 31, 2005, have concluded that, as of such date, our disclosure
controls and procedures were effective to ensure that information required to
be disclosed by us in reports that we file or submit under the Exchange Act is
accumulated and communicated to our management, including our chief executive
officer and chief financial officer, to allow timely decisions regarding
required disclosure and is recorded, processed, summarized and reported within
the periods specified by the SECs rules and forms.

There
were no changes in our internal controls over financial reporting identified with
the evaluation thereof that occurred during the period covered by this annual
report that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.

|                                           | 
|------------------------------------------ | 
|Item 16A.Audit Committee Financial Expert.

Our
board of directors has determined that Mr. David Assia, an independent
director, qualifies as an audit committee financial expert under SEC rules.

|                         | 
|------------------------ | 
|Item 16B.Code of Ethics.

We
have adopted a code of ethics that imposes certain policies relating to ethical
conduct on all of our employees, officers and directors, including our chief
executive officer, chief financial officer, principal accounting officer, and
persons performing similar functions.

|                                                 | 
|------------------------------------------------ | 
|Item 16C.Principal Accountant Fees and Services.

The
following table presents fees for professional audit services rendered by Kost,
Forer, Gabbay & Kaisierer, a member of Ernst & Young Global, for the
audit of our consolidated annual financial statements for the years ended
December 31, 2005 and 2004, and fees billed for other services rendered by
Ernst & Young LLP.

|                      |  |      |         |      |   |         |  |  |  | 
|--------------------- |  | ---- | ------- | ---- | - | ------- |  |  |  | 
|                      |  | 2005 |         | 2004 |   |         |  | 
|                      |  |      |         |      |   |         |  | 
|Audit Fees(1)         |  | $    | 455,369 |      | $ | 204,276 |  |  |  | 
|Audit-Related Fees(2) |  | $    | 64,913  |      | $ | 22,122  |  |  |  | 
|Tax Fees(3)           |  | $    | 164,614 |      | $ | 98,242  |  |  |  | 

(1) Audit fees
consist of fees for professional services rendered for the audit of our
consolidated financial statements and services normally provided by the
independent auditor in connection with statutory and regulatory filings or
engagements.

56

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(2)
Audit-related fees are fees principally for services that traditionally are
performed by the independent auditor, including: review of financial statements
included in our quarterly reports, accounting consultation and consultation
concerning financial accounting, reporting standards and implementation of the
Sarbanes-Oxley regulations.


(3) Tax
services fees consist of compliance fees for the preparation of original and
amended tax returns, claims for refunds and tax payment-planning services for
tax compliance, tax planning and tax advice. Tax service fees also include fees
relating to other tax advices, tax consulting and planning other than for tax
compliance and preparation.


Our
Audit Committee has adopted a policy for pre-approval of audit and non-audit
services. Under the policy, the Audit Committee Proposed services either may be
pre-approved without consideration of specific case-by-case services by the
Audit Committee (general pre-approval) or they may require the specific
pre-approval of the Audit Committee (specific pre-approval). The Audit
Committee employs a combination of these two approaches. Unless a type of
service has received general pre-approval, it will require specific
pre-approval by the Audit Committee if it is to be provided by the independent
auditor. The term of any general pre-approval is 12 months from the date of
pre-approval, unless the Audit Committee considers a different period and
states otherwise. The Audit Committee reviews annually and pre-approves the
services that may be provided by the independent auditor without obtaining
specific pre-approval from the Audit Committee. The Audit Committee adds to or
subtracts from the list of general pre-approved services from time to time,
based on subsequent determinations.

Pre-approval
fee levels or budgeted amounts for all services to be provided by the
independent auditor are to be established annually by the Audit Committee. Any
proposed services exceeding these levels or amounts require specific
pre-approval by the Audit Committee.

|                                                                    | 
|------------------------------------------------------------------- | 
|Item 16D.Exemptions for the Listing Standards for Audit Committees.

Not
applicable.

|                                                                                  | 
|--------------------------------------------------------------------------------- | 
|Item 16E.Purchase of Equity Securities by the Issuer and Affiliated
  Purchasers.

Not
applicable.

PART III.

|                              | 
|----------------------------- | 
|Item 17.Financial Statements.

Not
applicable

|                              | 
|----------------------------- | 
|Item 18.Financial Statements.

See
Consolidated Financial Statements, following the signature page and
certifications below.

|                  | 
|----------------- | 
|Item 19.Exhibits.

The
exhibits filed with or incorporated into this annual report are listed on the
index of exhibits below.

1.1 Articles
of Association, as amended, dated February 6, 2005 (1)

1.3 Memorandum
of Association of the registrant. (2)(3)

4.1 Strategic
Investor Agreement dated as of February 21, 2000, by and between the registrant
and Tamir FishmanVentures. (4)

4.2
Subscription by Aladdin for partnership units in Tamir Fishman. (4)

57

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4.3 Share
Purchase Agreement dated as of February 22, 2001, by and between the registrant
and Tamir Fishman Venture Capital Ltd. (4)

4.4 Form of
Indemnification Agreement between the registrant and each of the members of its
board of directors and its officers. (6)

4.5
Convertible Loan Agreement dated as of April 29, 2004, by and between
C-Signature Ltd. and the registrant. (5) (6)

8 List of
subsidiaries.*

10.1 Consent letter from Kost, Forer, Gabbay
& Kasierer.*

10.2 Consent
letter from Blick Rothenberg.*

11. Code of
Ethics (6)

12.1
Certification by Chief Executive Officer pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.*

12.2
Certification by Chief Financial Officer pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.*

13.1
Certification by Chief Executive Officer pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.*

13.2
Certification by Chief Financial Officer pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.*

---

*Filed herewith.


(1) Incorporated by reference from our
Registration Statement on Form F-3, File No. 333-121361, as amended, filed with
the Commission on March 8, 2005.(2) Incorporated by reference from our
Registration Statement on Form F-1 File No. 33-67980, as amended, filed with
the Commission on August 26, 1993.(3) English translation or summary from
Hebrew original.(4) Incorporated by reference from our 2000
Annual Report on Form 20-F filed with the Commission on June 30, 2001.(5) Portions of this exhibit have been
omitted pursuant to a request for confidential treatment.(6) Incorporated by reference from our 2003
Annual Report on Form 20-F filed with the Commission on June 30, 2004.

58

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SIGNATURES

Pursuant
to the requirements of Section 12 of the Securities Exchange Act of 1934, the
registrant certifies that it meets all the requirements for filing on Form 20-F
and has duly caused and authorized the undersigned to sign this Annual Report
on its behalf in the City of Tel Aviv, State of Israel, on this 27th day of
June 2006.

| |                                |                                                                                  | 
| | ------------------------------ | -------------------------------------------------------------------------------- | 
| | ALADDIN KNOWLEDGE SYSTEMS LTD.
| |                               
| | By:                            | /s/ Jacob
  (Yanki) Margalit                                                     | 
| |                                |                                                                                  | 
| |                                | Jacob
  (Yanki) Margalit 
  Chief Executive Officer and 
  Chairman of the Board

59

---



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                      |  |      |     | 
|----------------------------------------------------- |  | ---- | --- | 
|                                                      |  | Page
|Report of Independent Public
        Accounting Firm  |  |      | F-1 | 
|
|Report of Independent Auditors                        |  |      | F-2 | 
|Consolidated Balance Sheets                           |  |      | F-3 | 
|Consolidated Statements
        of Income             |  |      | F-5 | 
|Statements of Changes in
        Shareholders Equity |  |      | F-6 | 
|Consolidated Statements
        of Cash Flows         |  |      | F-7 | 
|Notes to Consolidated Financial
        Statements    |  |      | F-9 | 

---



(ERNST & YOUNG LOGO)

REPORT OF
INDEPENDENT PUBLIC ACCOUNTING FIRM

To the
Shareholders of

ALADDIN
KNOWLEDGE SYSTEMS LTD.

We have
audited the accompanying consolidated balance sheets of Aladdin Knowledge
Systems Ltd. (the Company) and its subsidiaries as of December 31, 2004 and
2005, and the related consolidated statements of income, changes in
shareholders equity and cash flows for each of the three years in the period
ended December 31, 2005.
These financial statements are the responsibility of the Companys management.
Our responsibility is to express an opinion on these financial statements,
based on our audits. We did not audit the financial statements of Aladdin
Western Europe Ltd., a wholly-owned U.K. subsidiary, which statements reflect
total assets constituting 5% in 2004 and 2% in 2005, and total revenues
constituting 15% in 2003 and 16% in 2004 and 13% in 2005 of the related
consolidated totals. Those statements were audited by other auditors whose
report has been furnished to us, and our opinion, insofar as it relates to the
data included for Aladdin Western Europe Ltd., is based solely on the report of
the other auditors.

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. We were
not engaged to perform an audit of the Companys internal control over
financial reporting. Our audits include
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Companys
internal control over financial reporting. Accordingly, we express no such
opinion. An audit also 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 and the report of other auditors provide a
reasonable basis for our opinion.

In our opinion,
based on our audits and the report of other auditors, the consolidated
financial statements referred to above present fairly, in all material
respects, the consolidated financial position of the Company and its
subsidiaries as of December 31, 2004 and 2005, and the consolidated results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2005, in conformity with U.S. generally accepted accounting
principles.

|                   |                                 
|------------------ | --------------------------------
|Tel-Aviv,
  Israel | /s/ KOST FORER GABBAY & KASIERER
|June 27,
  2006    | A Member of Ernst & Young Global

F - 1

---



REPORT OF INDEPENDENT AUDITORS

To the
shareholders of

ALADDIN WESTERN
EUROPE LTD

We have
audited the accompanying balance sheets of Aladdin Western Europe Ltd (the
Company), as of December 31, 2004 and 2005, and the related statements of
operations and changes in shareholders equity and cash flows for each of the
three years in the period ended December 31, 2005. These financial statements
are the responsibility of the Companys management. Our responsibility is to
express an opinion on these 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 consideration
of internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose
of expressing an opinion on the effectiveness of the Companys internal control
over financial reporting. Accordingly, we express no such opinion. An audit
also 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 financial statements referred to above present fairly, in all
material respects, the financial position of the Company as of December 31,
2004 and 2005 and the results of their operations and cash flows for each of
the three years in the period ended December 31, 2005, in conformity with U.S.
generally accepted accounting principles.

|                        |              
|----------------------- | -------------
|/s/BLICK ROTHENBERG     | 12 York Gate 
|Chartered
  Accountants | Regents Park
|Registered
  Auditors   | London       
|                        | NW1 4QS      

June 2, 2006

F - 2

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|CONSOLIDATED BALANCE SHEETS                               
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                               |  |              |        |      |   |         | 
|---------------------------------------------------------------------------------------------- |  | ------------ | ------ | ---- | - | ------- | 
|                                                                                               |  | December 31, |       
|                                                                                               |  |              |       
|                                                                                               |  | 2004         |        | 2005 |  
|                                                                                               |  |              |        |      |  
|                                                                                               |  |              |        |      |  
|ASSETS                                                                                         |  |              |        |      |   |         | 
|                                                                                               |  |              |        |      |   |         | 
|CURRENT
  ASSETS:                                                                              |  |              |        |      |   |         | 
|Cash and cash equivalents                                                                      |  | $            | 17,313 |      | $ | 28,426  | 
|Marketable securities (Note 3)                                                                 |  |              | 8,598  |      |   | 48,815  | 
|Trade receivables (net of allowance for
  doubtful accounts - $ 995 in 2004 and $ 377 in 2005) |  |              | 12,637 |      |   | 13,957  | 
|Other accounts receivable and prepaid
  expenses (Note 4)                                      |  |              | 3,446  |      |   | 3,517   | 
|Deferred income taxes (Note 13)                                                                |  |              | 657    |      |   | 1,159   | 
|Inventories (Note 5)                                                                           |  |              | 5,788  |      |   | 6,998   | 
|                                                                                               |  |              |        |      |   |         | 
|                                                                                               |  |              |        |      |   |         | 
|Total current assets                                                                           |  |              | 48,439 |      |   | 102,872 | 
|                                                                                               |  |              |        |      |   |         | 
|                                                                                               |  |              |        |      |   |         | 
|LONG-TERM INVESTMENTS:                                                                         |  |              |        |      |   |         | 
|Investment in other companies (Note 6)                                                         |  |              | 6,338  |      |   | 6,399   | 
|Severance pay fund                                                                             |  |              | 2,357  |      |   | 2,455   | 
|                                                                                               |  |              |        |      |   |         | 
|                                                                                               |  |              |        |      |   |         | 
|Total long-term investments                                                                    |  |              | 8,695  |      |   | 8,854   | 
|                                                                                               |  |              |        |      |   |         | 
|                                                                                               |  |              |        |      |   |         | 
|PROPERTY AND EQUIPMENT, NET (Note 7)                                                           |  |              | 2,234  |      |   | 3,081   | 
|                                                                                               |  |              |        |      |   |         | 
|                                                                                               |  |              |        |      |   |         | 
|OTHER ASSETS, NET                                                                              |  |              |        |      |   |         | 
|Intangible assets, net (Note 8)                                                                |  |              | 2,553  |      |   | 1,995   | 
|Goodwill (Note 9)                                                                              |  |              | 7,685  |      |   | 7,685   | 
|Deferred income taxes and other (Notes
10)                                                     |  |              | 1,288  |      |   | 1,391   | 
|                                                                                               |  |              |        |      |   |         | 
|                                                                                               |  |              |        |      |   |         | 
|Total other assets                                                                             |  |              | 11,526 |      |   | 11,071  | 
|                                                                                               |  |              |        |      |   |         | 
|                                                                                               |  |              |        |      |   |         | 
|Total assets                                                                                   |  | $            | 70,894 |      | $ | 125,878 | 
|                                                                                               |  |              |        |      |   |         | 

The
accompanying notes are an integral part of the consolidated financial
statements.

F - 3

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|CONSOLIDATED BALANCE SHEETS                               
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------ | ---- | - | ------- | -
|                                                                                                                                                                                                                                 |  | December 31, |       
|                                                                                                                                                                                                                                 |  |              |       
|                                                                                                                                                                                                                                 |  | 2004         |        | 2005 |  
|                                                                                                                                                                                                                                 |  |              |        |      |  
|LIABILITIES
  AND SHAREHOLDERS EQUITY                                                                                                                                                                                           |  |              |        |      |   |         |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|CURRENT LIABILITIES:                                                                                                                                                                                                             |  |              |        |      |   |         |  
|Trade payables                                                                                                                                                                                                                   |  | $            | 3,546  |      | $ | 4,454   |  
|Deferred revenues                                                                                                                                                                                                                |  |              | 4,793  |      |   | 5,645   |  
|Accrued expenses and other accounts payable
  (Note 11)                                                                                                                                                                          |  |              | 5,989  |      |   | 7,799   |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|Total current liabilities                                                                                                                                                                                                        |  |              | 14,328 |      |   | 17,898  |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|ACCRUED SEVERANCE PAY                                                                                                                                                                                                            |  |              | 3,129  |      |   | 3,243   |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|COMMITMENTS AND CONTINGENT LIABILITIES (Note
  12)                                                                                                                                                                               |  |              |        |      |   |         |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|SHAREHOLDERS EQUITY (Note 14):                                                                                                                                                                                                  |  |              |        |      |   |         |  
|Share capital: Ordinary shares of NIS 0.01
  par value - Authorized: 15,000,000 shares at December 31, 2004 and 2005;
  Issued and Outstanding : 12,345,536 and 14,485,063 shares at December 31, 2004
  and 2005, respectively. |  |              | 39     |      |   | 44      |  
|Additional paid-in capital                                                                                                                                                                                                       |  |              | 39,696 |      |   | 78,954  |  
|Deferred stock based compensation                                                                                                                                                                                                |  |              | (66    | )    |   | (15     | )
|Accumulated other comprehensive loss                                                                                                                                                                                             |  |              | (3,189 | )    |   | (3,559  | )
|Retained earnings                                                                                                                                                                                                                |  |              | 16,957 |      |   | 29,313  |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|Total shareholders equity                                                                                                                                                                                                       |  |              | 53,437 |      |   | 104,737 |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  
|Total liabilities and shareholders equity                                                                                                                                                                                       |  | $            | 70,894 |      | $ | 125,878 |  
|                                                                                                                                                                                                                                 |  |              |        |      |   |         |  

The accompanying notes are an
integral part of the consolidated financial statements.

F - 4

---



ALADDIN KNOWLEDGE SYSTEMS LTD.
AND ITS SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|CONSOLIDATED STATEMENTS OF INCOME                         
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                 |  |                           |        |      |   |        |   |   |        | 
|------------------------------------------------ |  | ------------------------- | ------ | ---- | - | ------ | - | - | ------ | 
|                                                 |  | Year ended
  December 31, |       
|                                                 |  |                           |       
|                                                 |  | 2003                      |        | 2004 |   | 2005   |  
|                                                 |  |                           |        |      |   |        |  
|Revenues (Note 15):                              |  |                           |        |      |   |        |   |   |        | 
|Software security                                |  | $                         | 43,521 |      | $ | 50,650 |   | $ | 56,578 | 
|Enterprise security                              |  |                           | 11,204 |      |   | 18,471 |   |   | 25,195 | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Total revenues                                   |  |                           | 54,725 |      |   | 69,121 |   |   | 81,773 | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Cost of revenues:                                |  |                           |        |      |   |        |   |   |        | 
|Software security                                |  |                           | 7,995  |      |   | 9,541  |   |   | 9,870  | 
|Enterprise security                              |  |                           | 1,804  |      |   | 4,240  |   |   | 7,101  | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Total cost of revenues                           |  |                           | 9,799  |      |   | 13,781 |   |   | 16,971 | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Gross profit                                     |  |                           | 44,926 |      |   | 55,340 |   |   | 64,802 | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Operating expenses:                              |  |                           |        |      |   |        |   |   |        | 
|Research and development                         |  |                           | 12,759 |      |   | 12,028 |   |   | 12,131 | 
|Selling and marketing                            |  |                           | 22,012 |      |   | 24,677 |   |   | 26,952 | 
|General and administrative                       |  |                           | 7,745  |      |   | 8,805  |   |   | 11,169 | 
|Settlement charge (Note 12b)                     |  |                           |       |      |   |       |   |   | 2,000  | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Total operating
  expenses                       |  |                           | 42,516 |      |   | 45,510 |   |   | 52,252 | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Operating income                                 |  |                           | 2,410  |      |   | 9,830  |   |   | 12,550 | 
|Financial income, net (Note 16a)                 |  |                           | 480    |      |   | 53     |   |   | 1,038  | 
|Other income (expenses), net                     |  |                           | (5     | )    |   | (138   | ) |   | 14     | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Income before taxes on income                    |  |                           | 2,885  |      |   | 9,745  |   |   | 13,602 | 
|Taxes on income (Note 13)                        |  |                           | 49     |      |   | 957    |   |   | 1,246  | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Income before equity in losses of an
  affiliate |  |                           | 2,836  |      |   | 8,788  |   |   | 12,356 | 
|Equity in losses of an affiliate                 |  |                           | (100   | )    |   |       |   |   |       | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Net income                                       |  | $                         | 2,736  |      | $ | 8,788  |   | $ | 12,356 | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Net earnings per share (Note 16b):               |  |                           |        |      |   |        |   |   |        | 
|Basic                                            |  | $                         | 0.24   |      | $ | 0.74   |   | $ | 0.89   | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|                                                 |  |                           |        |      |   |        |   |   |        | 
|Diluted                                          |  | $                         | 0.23   |      | $ | 0.68   |   | $ | 0.85   | 
|                                                 |  |                           |        |      |   |        |   |   |        | 

The
accompanying notes are an integral part of the consolidated financial
statements.

F - 5

---



ALADDIN KNOWLEDGE SYSTEMS LTD.
AND ITS SUBSIDIARIES


|                                                          
|----------------------------------------------------------
|STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY             
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|--------------------------------------------------------------------------- |  | --------------- | ----- | ------------------------------ | - | ----------------- |  | ------------------------------------- | ------ | --------------------------------------------------- | - | ------------------- | - | ------------------------------ | --------- | ------------------------------ | - | ------ | - | - | ------ | - | - | ------- | -
|                                                                            |  | Share
  capital |       | Additional
  paid-in
  capital |   | Treasury
  shares |  | Deferred
  Stock-based
  compensation |        | Accumulated
  other
  comprehensive
  Income (loss) |   | Retained
  earnings |   | Total
  comprehensive
  income |           | Total
  shareholders
  equity |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of January 1, 2003                                               |  | $               | 37    |                                | $ | 36,147            |  | $                                     | (1,164 | )                                                   | $ |                    |   | $                              | (4,529    | )                              | $ | 5,836  |   |   |        |   | $ | 36,327  |  
|Exercise of stock options                                                   |  |                 |      |                                |   |                  |  |                                       | 787    |                                                     |   |                    |   |                                |          |                                |   | (331   | ) |   |        |   |   | 456     |  
|Comprehensive income:                                                       |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Other comprehensive income:                                                 |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Unrealized gain on available-for-sale marketable
securities, net of
  taxes |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                | 260       |                                |   |       |   | $ | 260    |   |   | 260     |  
|Foreign currency translation adjustments                                    |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                | 1,177     |                                |   |       |   |   | 1,177  |   |   | 1,177   |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total other comprehensive income                                            |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                |          |                                |   |       |   |   | 1,437  |   |   |        |  
|Net income                                                                  |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                |          |                                |   | 2,736  |   |   | 2,736  |   |   | 2,736   |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total comprehensive income                                                  |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   | $ | 4,173  |   |   |         |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of December 31, 2003                                             |  |                 | 37    |                                |   | 36,147            |  |                                       | (377   | )                                                   |   |                    |   |                                | (3,092    | )                              |   | 8,241  |   |   |        |   |   | 40,956  |  
|Exercise of stock options                                                   |  |                 | 2     |                                |   | 3,335             |  |                                       | 377    |                                                     |   |                    |   |                                |          |                                |   | (72    | ) |   |        |   |   | 3,642   |  
|Deferred stock-based compensation                                           |  |                 |      |                                |   | 214               |  |                                       |       |                                                     |   | (214                | ) |                                |          |                                |   |       |   |   |        |   |   |        |  
|Amortization of deferred stock
compensation                                 |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   | 148                 |   |                                |          |                                |   |       |   |   |        |   |   | 148     |  
|Comprehensive income:                                                       |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Other comprehensive loss:                                                   |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Unrealized gain on available-for-sale marketable
securities, net of
  taxes |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                | 223       |                                |   |       |   | $ | 223    |   |   | 223     |  
|Foreign currency translation adjustments                                    |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                | 85        |                                |   |       |   |   | 85     |   |   | 85      |  
|Unrealized losses from hedging
transactions                                 |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                | (405      | )                              |   |       |   |   | (405   | ) |   | (405    | )
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total other comprehensive loss                                              |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                |          |                                |   |       |   |   | (97    | ) |   |        |  
|Net income                                                                  |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                |          |                                |   | 8,788  |   |   | 8,788  |   |   | 8,788   |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total comprehensive income                                                  |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   | $ | 8,691  |   |   |         |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of December 31, 2004                                             |  |                 | 39    |                                |   | 39,696            |  |                                       |       |                                                     |   | (66                 | ) |                                | (3,189    | )                              |   | 16,957 |   |   |        |   |   | 53,437  |  
|Issuance of Ordinary shares, net                                            |  |                 | 5     |                                |   | 38,773            |  |                                       |       |                                                     |   |                    |   |                                |          |                                |   |       |   |   |        |   |   | 38,778  |  
|Exercise of stock options                                                   |  |                 | **)  |                                |   | 485               |  |                                       |       |                                                     |   |                    |   |                                |          |                                |   |       |   |   |        |   |   | 485     |  
|Amortization of deferred stock-based compensation                           |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   | 51                  |   |                                |          |                                |   |       |   |   |        |   |   | 51      |  
|Comprehensive income:                                                       |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Other comprehensive loss:                                                   |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Unrealized loss on available-for-sale marketable securities, net of
  taxes |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                | (302      | )                              |   |       |   |   | (302   | ) |   | (302    | )
|Foreign currency translation adjustments                                    |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                | (492      | )                              |   |       |   |   | (492   | ) |   | (492    | )
|Unrealized gain from hedging transactions                                   |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                | 424       |                                |   |       |   |   | 424    |   |   | 424     |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total other comprehensive loss                                              |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                |          |                                |   |       |   |   | (370   | ) |   |        |  
|Net income                                                                  |  |                 |      |                                |   |                  |  |                                       |       |                                                     |   |                    |   |                                |          |                                |   | 12,356 |   |   | 12,356 |   |   | 12,356  |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total comprehensive income                                                  |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   | $ | 11,986 |   |   |         |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of December 31, 2005                                             |  | $               | 44    |                                | $ | 78,954            |  | $                                     |       |                                                     | $ | (15                 | ) | $                              | *) (3,559 | )                              | $ | 29,313 |   |   |        |   | $ | 104,737 |  
|                                                                            |  |                 |       |                                |   |                   |  |                                       |        |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  

|    |                                                                                            |  |   |        |  
|--- | ------------------------------------------------------------------------------------------ |  | - | ------ | -
|*)  | Composed as follows:                                                                       |  |   |        |  
|    | Accumulated unrealized gains from
available-for-sale marketable
  securities, net of taxes |  | $ | 114    |  
|    | Accumulated unrealized gains from hedging
transactions                                     |  |   | 19     |  
|    | Accumulated foreign currency translation
adjustments                                       |  |   | (3,692 | )
|    |                                                                                            |  |   |        |  
|    |                                                                                            |  |   |        |  
|    | Accumulated other comprehensive loss                                                       |  | $ | (3,559 | )
|    |                                                                                            |  |   |        |  
|    |                                                                                            |  |   |        |  
|**) | Represents
  an amount lower than $ 1.                                                     |  |   |        |  

The accompanying notes are an
integral part of the consolidated financial statements.

F - 6

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.AND ITS SUBSIDIARIES        
|CONSOLIDATED STATEMENTS OF CASH FLOWS                     
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                             |  |                           |        |      |   |         |   |   |         |  
|-------------------------------------------------------------------------------------------- |  | ------------------------- | ------ | ---- | - | ------- | - | - | ------- | -
|                                                                                             |  | Year ended
  December 31, |       
|                                                                                             |  |                           |       
|                                                                                             |  | 2003                      |        | 2004 |   | 2005    |  
|                                                                                             |  |                           |        |      |   |         |  
|Cash flows
  from operating activities:                                                      |  |                           |        |      |   |         |   |   |         |  
|                                                                                             |  |                           |        |      |   |         |   |   |         |  
|Net income                                                                                   |  | $                         | 2,736  |      | $ | 8,788   |   | $ | 12,356  |  
|Adjustments required to
reconcile net
  income to net cash provided by operating activities: |  |                           |        |      |   |         |   |   |         |  
|Depreciation and
amortization                                                                |  |                           | 2,110  |      |   | 2,072   |   |   | 1,967   |  
|Gain from sale of property and
equipment                                                     |  |                           | (15    | )    |   | (7      | ) |   | (22     | )
|Accrued interest on
available-for-sale
  marketable debt securities                          |  |                           |       |      |   |        |   |   | (262    | )
|Other- than- temporary decline
in fair
  value for available-for-sale marketable securities  |  |                           |       |      |   |        |   |   | 117     |  
|Equity in losses of an
affiliate                                                             |  |                           | 100    |      |   |        |   |   |        |  
|Increase (decrease) in accrued
severance
  pay, net                                          |  |                           | 31     |      |   | (74     | ) |   | 16      |  
|Amortization of deferred stock
compensation                                                  |  |                           |       |      |   | 148     |   |   | 51      |  
|Deferred income taxes,
net                                                                   |  |                           | (414   | )    |   |        |   |   | (803    | )
|Increase in trade
receivables                                                                |  |                           | (1,450 | )    |   | (2,515  | ) |   | (1,619  | )
|Decrease (increase) in
inventories                                                           |  |                           | 1,033  |      |   | 198     |   |   | (1,277  | )
|Decrease (increase) in other
accounts
  receivable and prepaid expenses                      |  |                           | 72     |      |   | (1,315  | ) |   | (189    | )
|Increase (decrease) in trade
payables                                                        |  |                           | (114   | )    |   | 1,160   |   |   | 936     |  
|Increase in deferred
revenues                                                                |  |                           | 1,092  |      |   | 1,378   |   |   | 852     |  
|Increase (decrease) in accrued
expenses and
  other accounts payable                         |  |                           | 723    |      |   | (997    | ) |   | 2,502   |  
|                                                                                            
|                                                                                             |  |                           |        |      |   |         |   |   |         |  
|                                                                                             |  |                           |        |      |   |         |   |   |         |  
|Net cash provided by operating
activities                                                    |  |                           | 5,904  |      |   | 8,836   |   |   | 14,625  |  
|                                                                                             |  |                           |        |      |   |         |   |   |         |  
|                                                                                             |  |                           |        |      |   |         |   |   |         |  
|Cash flows from investing
activities:                                                        |  |                           |        |      |   |         |   |   |         |  
|                                                                                             |  |                           |        |      |   |         |   |   |         |  
|Investment in
available-for-sale marketable
  securities                                     |  |                           |       |      |   | (7,000  | ) |   | (40,465 | )
|Investment in shares and
long-term loan of
  an affiliate                                    |  |                           | (100   | )    |   |        |   |   |        |  
|Purchase of property and
equipment                                                           |  |                           | (913   | )    |   | (1,237  | ) |   | (2,303  | )
|Proceeds from sale of property
and
  equipment                                               |  |                           | 139    |      |   | 15      |   |   | 34      |  
|Purchase of intangible
assets                                                                |  |                           |       |      |   | (1,220  | ) |   |        |  
|Investment in other
companies                                                                |  |                           | (1,710 | )    |   | (2,376  | ) |   | (850    | )
|Proceeds from return on
investment of other
  companies                                      |  |                           |       |      |   |        |   |   | 910     |  
|Payment for the purchase of
Aladdin
  Knowledge Espanã, S.L.,(1)                             |  |                           |       |      |   | (1,791  | ) |   |        |  
|                                                                                             |  |                           |        |      |   |         |   |   |         |  
|                                                                                             |  |                           |        |      |   |         |   |   |         |  
|Net cash used in investing activities                                                        |  |                           | (2,584 | )    |   | (13,609 | ) |   | (42,674 | )
|                                                                                             |  |                           |        |      |   |         |   |   |         |  

The
accompanying notes are an integral part of the consolidated financial
statements.

F - 7

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.AND ITS SUBSIDIARIES        
|CONSOLIDATED STATEMENTS OF CASH FLOWS                     
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |   | 
|-------------------------------------------------------------- | ----------------------------------------------------------------------------------- | ------------------------- | ------ | ---- | - | ------ | ----- | - | ------ | - | 
|                                                               |                                                                                     | Year ended
  December 31, |       
|                                                               |                                                                                     |                           |       
|                                                               |                                                                                     | 2003                      |        | 2004 |   | 2005   |      
|                                                               |                                                                                     |                           |        |      |   |        |      
|Cash flows
  from financing activities:                        |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|Proceeds from issuance of
shares, net                          |                                                                                     |                           |       |      |   |       |       |   | 38,778 |  
|Proceeds from exercise of
options                              |                                                                                     |                           | 456    |      |   | 3,642  |       |   | 485    |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|Net cash
  provided by financing activities                    |                                                                                     |                           | 456    |      |   | 3,642  |       |   | 39,263 |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|Effect of
  exchange rate changes on cash and cash equivalents |                                                                                     |                           | 276    |      |   | 157    |       |   | (101   | )
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|Increase
  (decrease) in cash and cash equivalents             |                                                                                     |                           | 4,052  |      |   | (974   | )     |   | 11,113 |  
|Cash and
  cash equivalents at the beginning of the year       |                                                                                     |                           | 14,235 |      |   | 18,287 |       |   | 17,313 |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|Cash and
  cash equivalents at the end of the year             |                                                                                     | $                         | 18,287 |      | $ | 17,313 |       | $ | 28,426 |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|Supplemental
  disclosure:                                     |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|Income taxes paid during the
year                              |                                                                                     | $                         | 490    |      | $ | 698    |       | $ | 1,058  |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|Non-cash
  activities:                                         |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|Investment in intangible
assets                                |                                                                                     | $                         |       |      | $ | 260    |       | $ |       |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |  
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |   | 
|(1)                                                            | Payment for purchase of Aladdin Knowledge
Espanã, S.L., (see Note 1b):              |                           |        |      |   |        |       |   |        |   | 
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |   | 
|                                                               | Fair value of assets acquired and
  liabilities assumed at the date of acquisition: |                           |        |      |   |        |       |   |        |   | 
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |   | 
|                                                               | Working capital net (excluding cash and
  cash equivalents in the amount of $ 188)  |                           |        |      |   | $      | 223   |   |        |   | 
|                                                               | Property and
  equipment                                                            |                           |        |      |   |        | 13    |   |        |   | 
|                                                               | Customer
  list                                                                     |                           |        |      |   |        | 1,151 |   |        |   | 
|                                                               | Goodwill                                                                            |                           |        |      |   |        | 404   |   |        |   | 
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |   | 
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |   | 
|                                                               |                                                                                     |                           |        |      |   | $      | 1,791 |   |        |   | 
|                                                               |                                                                                     |                           |        |      |   |        |       |   |        |   | 

The
accompanying notes are an integral part of the consolidated financial statements.

F - 8

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-------- | ------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 1:- | GENERAL
|         |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | a.      | Aladdin
  Knowledge Systems Ltd. and its wholly-owned subsidiaries (collectively, the
  Company or Aladdin) is a global provider of security solutions that
  reduce software theft, authenticate network users and protect against
  unwanted Internet and e-mail content, including spam and viruses. The
  Companys security products are organized into two segments: Software Digital
  Rights Management, or DRM, and enterprise security.                                                                
|         |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |         | The
  Companys software DRM products allow software publishers to manage licensing
  and distribution of their software while limiting revenue loss from software
  theft and piracy.  The HASP products
  include: HASP HL and HASP NET, hardware-based software security systems and
  HASP SL, a software marketing, licensing and distribution platform.                                                                                                                                                        
|         |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |         | Within the enterprise security segment, Aladdin develops and markets
  its patented USB-based eToken hardware solution for strong
   authentication and digital identity management using a portable
  device, and the eSafe line of integrated content security solutions that
  protects PCs and networks against viruses, worms, spam, spyware, and
  non-productive and malicious Internet-borne content.                                                                                                        
|         |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |         | The Company
  is dependent upon sole source suppliers for certain key components used in
  its products. Although there are a limited number of manufacturers of these
  particular components, the Companys management believes that other suppliers
  could provide similar components at comparable terms. A change in suppliers,
  however, could cause a delay in manufacturing and a possible loss of sales,
  which could adversely affect the operating results of the Company and its
  financial position.
|         |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | b.      | Acquisition
  of Aladdin Knowledge Systems España, S.L.:                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |         | On July 16,
  2004, the Company entered into a Share Purchase Agreement with the
  shareholders of its former distributor, Aladdin Knowledge Systems España, S.L
  (Aladdin España ), in order to enhance the service provided to
  Spanish-speaking countries. Pursuant to the agreement, the Company acquired
  100% of Aladdin Españas shares, and thereafter it became a wholly-owned
  subsidiary of the Company.                                                                                            
|         |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |         | The total
  consideration for the purchase of the shares was $1,979 (including
  approximately $136 acquisition costs). .                                                                                                                                                                                                                                                                                                                                                                                            
|         |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |         | Aladdin
  España is engaged in the marketing, distributing, selling, licensing and
  support of certain proprietary software products of the Company in Spain. The
  acquisition has been accounted for using the purchase method of accounting
  and, accordingly, the purchase price has been allocated to the assets
  acquired and the liabilities assumed based on the estimated fair value at the
  date of acquisition. Regarding the allocation of the goodwill, see also
  Note 9.                          

F - 9

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                 |                                                                                                                                                
|-------- | --------------- | -----------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 1:- | GENERAL (Cont.)
|         |                 |                                                                                                                                                
|         |                 | Based upon a
  valuation of tangible and intangible assets acquired, the Company has
  allocated the total cost of the acquisition, as follows:

| |                             |  |                  |       | 
| | --------------------------- |  | ---------------- | ----- | 
| |                             |  | July 16, 
  2004 |      
| |                             |  |                  |      
| |                             |  |                  |       | 
| |                             |  |                  |       | 
| | Current
  assets            |  | $                | 802   | 
| | Property and
  equipment    |  |                  | 13    | 
| | Intangible
  assets:        |  |                  |       | 
| | Customer list               |  |                  | 1,151 | 
| | Goodwill                    |  |                  | 404   | 
| |                             |  |                  |       | 
| |                             |  |                  |       | 
| | Total assets
  acquired     |  |                  | 2,370 | 
| |                             |  |                  |       | 
| |                             |  |                  |       | 
| | Liabilities
  assumed:      |  |                  |       | 
| | Current liabilities         |  |                  | 391   | 
| |                             |  |                  |       | 
| |                             |  |                  |       | 
| | Total
  liabilities assumed |  |                  | 391   | 
| |                             |  |                  |       | 
| |                             |  |                  |       | 
| | Net assets
  acquired       |  | $                | 1,979 | 
| |                             |  |                  |       | 

| |                                                                                                                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The
  following represents the unaudited pro-forma results of operations for the
  years ended December 31, 2003 and 2004 assuming that the Aladdin España
  acquisition had been consummated as of January 1, 2003 and 2004,
  respectively. Intercompany transactions prior to the acquisition have been
  eliminated.

| |                                  |  |             |        |      |   |        | 
| | -------------------------------- |  | ----------- | ------ | ---- | - | ------ | 
| |                                  |  | Year ended  |       
| |                                  |  | December 31 |       
| |                                  |  |             |       
| |                                  |  | 2003        |        | 2004 |  
| |                                  |  |             |        |      |  
| |                                  |  | Unaudited   |       
| |                                  |  |             |       
| |                                  |  |             |        |      |   |        | 
| | Revenues                         |  | $           | 55,690 |      | $ | 69,979 | 
| |                                  |  |             |        |      |   |        | 
| |                                  |  |             |        |      |   |        | 
| | Net income                       |  | $           | 2,842  |      | $ | 9,073  | 
| |                                  |  |             |        |      |   |        | 
| |                                  |  |             |        |      |   |        | 
| | Basic net
  earnings per share   |  | $           | 0.25   |      | $ | 0.76   | 
| |                                  |  |             |        |      |   |        | 
| |                                  |  |             |        |      |   |        | 
| | Diluted net
  earnings per share |  | $           | 0.24   |      | $ | 0.70   | 
| |                                  |  |             |        |      |   |        | 

| |                                                                                                                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The
  pro-forma financial information is not necessarily indicative of the
  consolidated results that would have been attained had the acquisition taken
  place at the beginning of 2004 or 2003, nor is it necessarily indicative of
  future results.

F - 10

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Basis of presentation:                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                         
|         | The consolidated
  financial statements have been prepared according to United States Generally
  Accepted Accounting Principles (U.S. GAAP).                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                         
|         | Use of estimates:                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                         
|         | The
  preparation of financial statements in conformity with generally accepted
  accounting principles requires management to make estimates and assumptions
  that affect the amounts reported in the financial statements and accompanying
  notes. Actual results could differ from these estimates.
|         |                                                                                                                                                                                                                                                                                                         
|         | Financial statements in United States dollars:                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                         
|         | 1.                                                                                                                                                                                                                                                                                                       | The majority
  of the revenues of the Company and certain of its subsidiaries is generated
  in United States dollars (dollar). In addition, a substantial portion of
  the Companys and certain of its subsidiaries costs is incurred in dollars.
  The Companys management believes that the dollar is the primary currency of
  the economic environment in which the Company and certain of its subsidiaries
  operate. Thus, the functional and reporting currency of the Company and
  certain of its subsidiaries is the dollar. Accordingly, monetary accounts
  maintained in currencies other than the dollar are remeasured into U.S.
  dollars in accordance with Statement of Financial Accounting Standard Board
  No. 52 Foreign Currency Translation.
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                          | All
  transactions gains and losses of the remeasured monetary balance sheet items
  are reflected in the statement of operations as financial income or expenses,
  as appropriate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | 2.                                                                                                                                                                                                                                                                                                       | The
  financial statements of a foreign Subsidiary, whose functional currency is
  not the U.S. dollar, have been translated into U.S. dollars. All balance
  sheet accounts have been translated using the exchange rates in effect at the
  balance sheet date. Statement of operations amounts have been translated
  using the average exchange rate for the year. The resulting aggregate
  translation adjustments are reported as a component of accumulated other
  comprehensive loss in shareholders equity.                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Principles of consolidation:                                                                                                                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                         
|         | The
  consolidated financial statements include the accounts of the Company and its
  wholly-owned subsidiaries. Intercompany transactions and balances, including
  profits from intercompany sales not yet realized outside the Group, have been
  eliminated upon consolidation.                     
|         |                                                                                                                                                                                                                                                                                                         
|         | Cash and cash equivalents:                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                         
|         | Cash and
  cash equivalents include short-term, highly liquid investments that are
  readily convertible to cash with maturities of three months or less at the
  date acquired.                                                                                                                        

F - 11

---



|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|----------------------------------------------------------
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | Marketable securities:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | Management
  determines the appropriate classification of its investments in marketable
  debt securities at the time of purchase and re-evaluates such designations as
  of each balance sheet date. During 2005 and 2004, all marketable securities
  covered by Statement of Financial Accounting Standard No. 115 Accounting for
  Certain Investments in Debt and Equity Securities were designated as
  available-for-sale.                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | Accordingly,
  these securities are stated at fair value, with unrealized gains and losses
  reported in accumulated other comprehensive loss, a separate component of
  shareholders equity, net of taxes. Realized gains and losses on sales of
  investments, and impairment of investments, as determined on a specific
  identification basis, are included in the consolidated statement of
  operations.                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | Following
  SEC Staff Accounting Bulletin No. 59 and EITF 03-1, management evaluates in each
  period whether declines in the market value of its securities are other than
  temporary. Where such declines are determined to be other than temporary,
  those securities are written-down to their current market value with the
  amount of the write-down included in financial expenses.                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | Investment in other
  companies:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | The
  investment in companies, in which the Company holds less than 20%, is stated
  at cost, since the Company does not have the ability to exercise significant
  influence over operating and financial policies of the investees. The
  Investment in IDesia Ltd. (Formerly: C-Signature Ltd.) (IDesia) in which
  the Company holds 27.4% is accounted in accordance with EITF 02-14 Whether
  an Investor Should Apply the Equity Method of Accounting to Company
  Investments Other than Common Stock. The Company determined that since its
  investment in IDesias Preferred Shares is not in-substance common stock, the
  equity method should not be applied (see Note 6b).
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | The
  Companys investment in the other companies is reviewed for impairment
  whenever events or changes in circumstances indicate that the carrying amount
  of an investment may not be recoverable, in accordance with Accounting
  Principle Board Opinion No. 18, The Equity Method of Accounting for Investments
  in Common Stock (APB No. 18). As of December 31, 2005, based on
  managements most recent analysis, no impairment losses have been identified.                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | Inventories:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | Inventories
  are stated at the lower of cost or market value. Inventory provisions are
  provided to cover risks arising from slow-moving items, technological
  obsolescence, excess inventories and for market prices lower than cost.                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         | Cost is
  determined for all types of inventory using the moving average cost method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

F - 12

---



|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|----------------------------------------------------------
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                       
|-------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                               
|         |                                                                                                                                                                                                                       
|         | Property and equipment:                                                                                                                                                                                               
|         |                                                                                                                                                                                                                       
|         | Property and
  equipment are stated at cost, net of accumulated depreciation. Depreciation
  is calculated by the straight-line method over the estimated useful lives of
  the assets, at the following annual rates:

| |                                      |  |                                                                                                | 
| | ------------------------------------ |  | ---------------------------------------------------------------------------------------------- | 
| |                                      |  | %                                                                                              | 
| |                                      |  |                                                                                                | 
| |                                      |  |                                                                                                | 
| | Computers
  and peripheral equipment |  | 33                                                                                             | 
| | Office
  furniture and equipment     |  | 7 - 20                                                                                         | 
| | Motor
  vehicles                     |  | 15                                                                                             | 
| | Leasehold
  improvements             |  | Over the shorter of the term of
  the lease (including renewal 
  option) or useful life lease | 

| |                                                                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Intangible assets:                                                                                                                                                                                                                                                                                                                                             
| |                                                                                                                                                                                                                                                                                                                                                                
| | Intangible
  assets acquired are amortized over their useful lives using a method of
  amortization that reflects the pattern in which the economic benefits of the
  intangible assets are consumed or otherwise used up, in accordance with
  Statement of Financial Accounting Standards No. 142 Goodwill and Other
  Intangible Assets, (SFAS No. 142).
| |                                                                                                                                                                                                                                                                                                                                                                
| | Indefinite-lived
  intangible assets are not amortized, but rather are subject to an annual
  impairment test.                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                
| | Other
  intangible assets are amortized using the straight-line method over the
  following estimated useful life:                                                                                                                                                                                                                                             

| |                      |  |  |       | 
| | -------------------- |  |  | ----- | 
| |                      |  |  | Years | 
| |                      |  |  |       | 
| |                      |  |  |       | 
| | Current
  technology |  |  | 5     | 
| | Customer
  list      |  |  | 7     | 
| | Domain name          |  |  | 3     | 
| | Patent               |  |  | 13.5  | 

F - 13

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Goodwill:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Goodwill is
  measured as the excess of the cost of an acquired company over the sum of the
  amounts assigned to tangible and identifiable intangible assets acquired less
  liabilities assumed. Goodwill is not amortized, but rather reviewed for
  impairment at least annually in accordance with the provisions of SFAS No.
  142. The goodwill impairment test under SFAS No. 142 involves a two-step
  approach. Under the first step, the Company determines the fair value of each
  reporting unit to which goodwill has been assigned. The reporting units of
  the Company for purposes of the impairment test are the Companys two
  operating segments, the software security DRM, and enterprise security, as
  these are the components of the business for which discrete financial
  information is available and segment management regularly reviews the
  operating results of those components. The Company then compares the fair
  value of each reporting unit to its carrying value, including goodwill. The
  Company estimates the fair value of each reporting unit by estimating the
  present value of the reporting units future cash flows. If the fair value
  exceeds the carrying value, no impairment loss is recognized. If the carrying
  value exceeds the fair value, the goodwill of the reporting unit is
  considered potentially impaired and the second step is completed in order to
  measure the impairment loss. The Company performs the annual impairment tests
  during the fourth fiscal quarter. During 2003, 2004 and 2005, no impairment
  losses were identified.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Impairment of long-lived assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | The
  long-lived assets of the Company and its subsidiaries and certain
  identifiable intangible assets are reviewed for impairment in accordance with
  Statement of Financial Accounting Standard No. 144 Accounting for the
  Impairment or Disposal of Long-Lived Assets(SFAS No. 144), whenever
  events or changes in circumstances indicate that the carrying amount of an
  asset may not be recoverable. Recoverability of assets to be held and used is
  measured by a comparison of the carrying amount of an asset to the future
  undiscounted cash flows expected to be generated by the assets. If such
  assets are considered to be impaired, the impairment to be recognized is
  measured by the amount by which the carrying amount of the assets exceeds the
  fair value of the assets. During 2003, 2004 and 2005, no impairment losses
  were identified.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Income taxes:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | The Company
  and its subsidiaries account for income taxes in accordance with Statement of
  Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS
  No. 109). This Statement prescribes the use of the liability method whereby
  deferred tax assets and liability account balances are determined based on
  the differences between financial reporting and tax bases of assets and
  liabilities and are measured using the enacted tax rates and laws that will
  be in effect when the differences are expected to reverse. The Company and
  its subsidiaries provide a valuation allowance, if necessary, to reduce
  deferred tax assets to the amounts that are more likely-than-not to be
  realized.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

F - 14

---



|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|---------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|NOTE 2:-                                                   | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           | Research and development costs:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           | Research and
  development costs are charged to the statement of operations as incurred.
  Statement of Financial Accounting Standard No. 86, Accounting for the Costs
  of Computer Software to be Sold, Leased or Otherwise Marketed (SFAS No.
  86), requires capitalization of certain software development costs,
  subsequent to the establishment of technological feasibility.                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           | Based on the
  Companys product development process, technological feasibility is
  established upon completion of a working model. Costs incurred by the Company
  between completion of the working models and the point at which the products
  are ready for general release have been insignificant. Therefore, all
  research and development costs have been expensed.                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           | Revenue recognition:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           | The Company
  derives revenues from sales of its hardware products (HASP HL, HASP NET and
  eToken) and from licensing the right to use its software products (eSafe and
  HASP SL) which include maintenance and support.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           | The hardware
  based products contain an insignificant embedded software element which is
  incidental to the product as a whole since the embedded software is not
  marketed or sold separately and is used solely in connection with the
  operation of the hardware products.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           | The Company
  generates revenues from its products directly to end-users and indirectly,
  mostly through value-added resellers, original equipment manufacturers and
  independent distributors (all of whom are considered end-users). Other than
  pricing terms which may differ due to the different volume of purchases
  between resellers, manufacturers and distributors and end-users, there are no
  material differences in the terms and arrangements involving direct and
  indirect customers. All of the Companys products sold through agreements with
  value-added resellers, original equipment manufacturers and independent
  distributors are non-exchangeable, non refundable, non-returnable and without
  any rights of price protection or stock rotation. Accordingly, the Company
  considers them all as end-users.
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           | The Company
  accounts for its software sales in accordance with Statement of Position No.
  97-2, Software Revenue Recognition, as amended (SOP No. 97-2) and for its
  hardware products in accordance with Staff Accounting Bulletin No. 104 Revenue
  Recognition (SAB 104) when persuasive evidence of an arrangement exists,
  delivery has occurred, the vendors fee is fixed or determinable, no further
  obligation exists and collectibility is probable.                                                                                                                                                                                                                                                                                                                                                                     

F - 15

---



|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|---------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|NOTE 2:-                                                   | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                           | Persuasive evidence of an arrangement exists.
  The Company determines that persuasive evidence of an arrangement exists with
  respect to a customer when it has a written contract, which is signed by both
  the Company and the customer or a purchase order from the customer
  (documentation is dependent on the business practice for each type of
  customer).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                           | Delivery has occurred. The Companys
  hardware and software products may be physically delivered to the customer,
  or with regard to software products, the products may be electronically
  delivered to the customer. The Company determines that delivery of hardware
  products has occurred when the title and risk of loss have been transferred
  to the customer. In connection with delivery of software products, the
  Company determines that delivery has occurred upon shipment of the software or,
  when the software is made available to the customer through electronic
  delivery, when the customer has been provided with access codes that allow
  the customer to take immediate possession of the software.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                           | The fee is fixed or determinable. Generally,
  payments that extend beyond 30 days from the contract date but are due within
  six months are deemed to be fixed or determinable based on the Companys
  successful collection history on such arrangements without giving consenting.
  Arrangements with payment terms extending beyond these customary payment
  terms are considered not to be fixed or determinable, and revenue from such
  arrangements is recognized as payments become due from the customer, provided
  that all other revenue recognition criteria have been met.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                           | Collectibility is probable. The Company
  determines whether collectibility is probable on a case-by case basis. When
  assessing probability of collection, the Company considers the customers
  financial condition, the number of years in business with the customer and
  the history of collection. If the Company determines from the outset that
  collectibility is not probable based upon its review process, revenue is
  recognized as payments are received.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                           | With regard
  to software arrangements involving multiple elements such as software product
  and maintenance and support, the Company has adopted Statement of Position
  No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition with
  Respect to Certain Transactions (SOP No. 98-9). According to SOP No.
  98-9, revenues should be allocated to the different elements in the
  arrangement under the residual method when Vendor Specific Objective
  Evidence (VSOE) of fair value exists for all undelivered elements and no
  VSOE exists for the delivered elements. Under the residual method, at the
  outset of the arrangement with the customer, the Company defers revenue for
  the fair value of its undelivered elements (maintenance and support) and
  recognizes revenue for the remainder of the arrangement fee attributable to
  the elements initially delivered in the arrangement (software product) when
  the basic criteria in SOP No. 97-2 have been met. Any discount in the
  arrangement is allocated to the delivered element. Maintenance and support
  revenue is deferred and recognized on a straight-line basis over the term of
  the maintenance and support agreement. The VSOE of fair value of the
  undelivered elements (maintenance and support) is determined based on the
  price charged for the undelivered element when sold separately. Time-based
  licenses include maintenance and on-going support. VSOE of fair value does
  not exist for the related support arrangement as maintenance is not priced or
  offered separately for such arrangements. In these cases, the Company
  recognizes the license and maintenance revenue ratably over the period of
  each arrangement.

F - 16

---



|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|---------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data
|                                                          
|NOTE 2:-                                                   | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | In certain
  cases where a multiple elements arrangement exist, the fair value of each
  element is determined based on vendor specific objective evidence for that
  element and revenue is allocated to each element based upon its fair value.
  The revenue associated with each element is recognized using the respective
  methodology discussed above. The Company uses the residual method in
  accordance with SOP 97-2 and EITF 00-21 Revenue Arrangement with Multiple
  Deliverables                                                                                                                            
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | Deferred
  revenues include unearned amounts received from maintenance and support
  contracts and amounts received from customers but not recognized as revenues.                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | Severance pay:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | The
  Companys liability for its Israeli employees severance pay is calculated
  pursuant to Israels Severance Pay Law, based on the most recent salary of
  the Israeli employees, multiplied by the number of years of employment as of
  balance sheet date. Employees are entitled to one months salary for each
  year of employment, or a portion thereof. The Companys liability for all of
  its employees in Israel is fully provided by monthly deposits with severance
  pay funds, insurance policies and by an accrual. The value of those policies
  is recorded as an asset in the Companys balance sheet.
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | The
  deposited funds include profits accumulated up to the balance sheet date. The
  deposited funds may be withdrawn, only upon fulfillment of the obligation
  pursuant to Israels Severance Pay Law or labor agreements. The value of the
  deposited funds is based on the cash surrendered value of these policies, and
  includes immaterial profits.                                                                                                                                                                                                                                                                  
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | Severance
  pay expenses for the years ended December 31, 2003, 2004 and 2005 amounted to
  $1,411, $1,057 and $1,336, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | Advertising expenses:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | Advertising
  expenses are charged to the statement of operations, as incurred. Advertising
  expenses for the years ended December 31, 2003, 2004 and 2005 were $2,773,
  $3,488 and $4,504, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | Concentrations of credit risks:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | Financial
  instruments that potentially subject the Company to concentrations of credit
  risk consist principally of cash and cash equivalents, marketable securities
  and trade receivables.                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                           | The majority
  of the Companys cash and cash equivalents are invested in U.S. dollar
  deposits with major banks in Israel, the United States, Japan, Germany, the
  Netherlands, United Kingdom, Spain and France. Management believes that the
  financial institutions that hold the Companys investments are financially sound
  and accordingly, minimal credit risk exists with respect to these
  investments. Such cash and cash equivalents in the United States may be in
  excess of insured limits and are not insured in other jurisdictions.                                                                   

F - 17

---



|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|---------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|NOTE 2:-                                                   | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           | The trade
  receivables of the Company and its subsidiaries are derived from sales to
  customers located primarily in the United States, Europe, Japan and Israel.
  The Company performs ongoing credit evaluations of its customers and, to date
  has not experienced any material losses. An allowance for doubtful accounts
  is determined with respect to those amounts that the Company has determined
  to be doubtful of collection, on a specific account basis.                                                                                                                                                                              
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           | The doubtful
  accounts expenses for the years ended December 31, 2003, 2004 and 2005 were
  $240, $194 and $114, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           | The
  Companys marketable securities include investments in U.S. Government
  Auction rate and Equity traded. Management believes that minimal credit risk
  exists with respect to these marketable securities.                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           | Basic and diluted net earnings per share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           | Basic net
  earnings per share are computed based on the weighted average number of
  Ordinary shares outstanding during each year. Diluted net earnings per share
  are computed based on the weighted average number of Ordinary shares
  outstanding during each year, plus dilutive potential Ordinary shares
  considered outstanding during the year, in accordance with Statement of
  Financial Accounting Standard No. 128, Earnings per Share (SFAS No. 128).                                                                                                                                                                               
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           | The total
  weighted average number of outstanding options excluded from the calculations
  of diluted net earnings per share was 0, 0 and 90,925 for the years ended
  December 31, 2003, 2004 and 2005, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           | Accounting for stock-based compensation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           | The Company
  has elected to follow Accounting Principles Board Opinion No. 25, Accounting
  for Stock Issued to Employees (APB No. 25) and FASB Interpretation No. 44
  Accounting for Certain Transactions Involving Stock Compensation, in
  accounting for its employee stock option plans. Under APB No. 25, when the
  exercise price of an employee stock option is equivalent to or above the
  market price of the underlying shares on the date of grant no compensation
  expense is recognized.                                                                                                                                         
|                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                           | The Company
  adopted the disclosure provisions of Statement of Financial Accounting
  Standards No. 148, Accounting for Stock-Based Compensation - Transition and
  Disclosure (SFAS No. 148), which amended certain provisions of
  Statement of Financial Accounting Standard No. 123 (SFAS No. 123) to
  provide alternative methods of transition for an entity that voluntarily
  changes to the fair value based method of accounting for stock-based employee
  compensation, effective as of the beginning of the fiscal year. The Company
  continues to apply the provisions of APB No. 25, in accounting for
  stock-based compensation.

F - 18

---



|                                                           |                                                      
|---------------------------------------------------------- | -----------------------------------------------------
|                                                           | ALADDIN KNOWLEDGE SYSTEMS LTD.
  AND ITS SUBSIDIARIES
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                 |                                                      
|                                                           |                                                      
|U.S. dollars in thousands, except share and per share data |                                                      

|         |                                                                                                                                                                                                                                                                       
|-------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                       
|         | Pro forma
  information regarding the Companys net income and net earnings per share is
  required by SFAS No. 123 and has been determined as if the Company had
  accounted for its employee stock options under the fair value method
  prescribed by SFAS No. 123.
|         |                                                                                                                                                                                                                                                                       
|         | The fair
  value for options granted in 2003, 2004 and 2005 is amortized over their
  vesting period and estimated at the date of grant using a Black-Scholes
  options pricing model with the following weighted average assumptions:                                

| |                                           |  |                         |  |           |  |         | 
| | ----------------------------------------- |  | ----------------------- |  | --------- |  | ------- | 
| |                                           |  | Year ended December 31, | 
| |                                           |  |                         | 
| |                                           |  | 2003                    |  | 2004      |  | 2005    | 
| |                                           |  |                         |  |           |  |         | 
| | Expected dividend
yield                   |  | 0%                      |  | 0%        |  | 0%      | 
|
| | Expected volatility                       |  | 80.2%                   |  | 75.4%     |  | 78.9%   | 
|
| | Risk-free interest
rate                   |  | 2.5%                    |  | 2.8%      |  | 3.9%    | 
|
| | Average Expected life of up
to            |  | 4.5 years               |  | 4.5 years |  | 6 years | 
| |                                          
| | Pro forma
information under SFAS No. 123:

| |                                                          |  |                         |       |      |   |       |  |   |        | 
| | -------------------------------------------------------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | ------ | 
| |                                                          |  | Year ended December 31, |      
| |                                                          |  |                         |       |      |   |       | 
| |                                                          |  | 2003                    |       | 2004 |   | 2005  | 
| |                                                          |  |                         |       |      |   |       | 
| | Net income - as reported                                 |  | $                       | 2,736 |      | $ | 8,788 |  | $ | 12,356 | 
|
| | Add: stock-based employee
  compensation intrinsic value |  |                         |      |      |   | 148   |  |   | 51     | 
|
| | Deduct: stock-based employee
  compensation - fair value |  |                         | 542   |      |   | 1,059 |  |   | 1,659  | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| | Pro forma net income:                                    |  | $                       | 2,194 |      | $ | 7,877 |  | $ | 10,748 | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| | Net earnings per share:                                  |  |                         |       |      |   |       |  |   |        | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| | Basic net earnings per Ordinary share, as
  reported     |  | $                       | 0.24  |      | $ | 0.74  |  | $ | 0.89   | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| | Diluted net earnings per Ordinary share, as
  reported   |  | $                       | 0.23  |      | $ | 0.68  |  | $ | 0.85   | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| | Basic pro forma net earnings per Ordinary
  share        |  | $                       | 0.19  |      | $ | 0.66  |  | $ | 0.77   | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 
| | Diluted pro forma net earnings per Ordinary
  share      |  | $                       | 0.18  |      | $ | 0.61  |  | $ | 0.74   | 
| |                                                          |  |                         |       |      |   |       |  |   |        | 

F - 19

---



|                                                           |                                                      
|---------------------------------------------------------- | -----------------------------------------------------
|                                                           | ALADDIN KNOWLEDGE SYSTEMS LTD.
  AND ITS SUBSIDIARIES
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                 |                                                      
|                                                           |                                                      
|U.S. dollars in thousands, except share and per share data |                                                      

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|-------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Fair value of financial instruments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The
  following methods and assumptions were used by the Company and its
  subsidiaries in estimating their fair value disclosures for financial
  instruments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | 1.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | The carrying
  amount of cash and cash equivalents, trade receivables, other accounts
  receivable, trade payables and other accounts payable approximates their fair
  values due to the short-term maturities of these instruments.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | 2.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | The fair
  value of short-term marketable securities is based on quoted market prices.                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | 3.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | The fair
  value of derivative instruments is estimated by obtaining quotes from
  brokers.                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Treasury Shares:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The Company
  repurchases its Ordinary shares from time to time on the open market and
  holds such shares as Treasury shares. The Company presents the cost to
  repurchase Treasury shares as a reduction in shareholders equity.                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Derivative instruments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The Company
  has instituted a foreign currency cash flow hedging program using put and
  call options to hedge against the risk of overall changes in cash flows
  resulting from forecasted foreign currency sales during the year. These
  option contracts are designated as cash flow hedges, as defined by Financial
  Accounting Standards Board Statement No. 133, Accounting for Derivative
  Instruments and Hedging Activities (SFAS 133).                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | SFAS 133
  requires companies to recognize all of its derivative instruments as either
  assets or liabilities in the statement of financial position at fair value.
  The accounting for changes in the fair value (i.e., gains or losses) of a
  derivative instrument depends on whether it has been designated and qualifies
  as part of a hedging relationship and further, on the type of hedging
  relationship.                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | For those
  derivative instruments that are designated and qualify as hedging
  instruments, a company must designate the hedging instrument, based upon the
  exposure being hedged, as a fair value hedge, cash flow hedge or a hedge of a
  net investment in a foreign operation.                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | For
  derivative instruments that are designated and qualify as a cash flow hedge
  (i.e., hedging the exposure to variability in expected future cash flows that
  is attributable to a particular risk), the effective portion of the gain or
  loss on the derivative instrument is reported as a component of other
  comprehensive loss and reclassified into earnings in the same period or
  periods during which the hedged transaction affects earnings. The remaining
  gain or loss on the derivative instrument in excess of the cumulative change
  in the present value of future cash flows of the hedged item, if any, is
  recognized in current earnings during the period of change.

F - 20

---



|                                                           |                                                      
|---------------------------------------------------------- | -----------------------------------------------------
|                                                           | ALADDIN KNOWLEDGE SYSTEMS LTD.
  AND ITS SUBSIDIARIES
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                 |                                                      
|                                                           |                                                      
|U.S. dollars in thousands, except share and per share data |                                                      

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | All other
  derivatives which do not qualify for hedge accounting under FAS 133, are
  recognized on the balance sheet at their fair value, with changes in the fair
  value carried to the statements of income included in the financial expenses.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The Company
  recognized net income (loss) from derivative instruments of $ 793, $ 437 and
  $ 324 during the years ended December 31, 2003, 2004 and 2005,
  respectively. An amount of $ 793, $ 203 and ($ 132) was offset against the
  revenues in the statement of income during the years ended December 31, 2003,
  2004 and 2005, respectively and an amount of $ 0, $ 234 and $ 456 was included
  in financial income, net, during the years ended December 31, 2003, 2004 and
  2005, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The balance
  in accumulated other comprehensive loss related to derivative instruments as
  of December 31, 2005 is expected to be recognized in earnings over the next
  year.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Reclassification:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Certain
  amounts from prior years have been reclassified to conform to the current
  period presentation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The
  reclassification had no effect on previously reported net income,
  shareholders equity or cash flows.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Impact of recently issued accounting standards:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | On December
  16, 2004, the Financial Accounting Standards Board (FASB) issued FASB
  Statement No. 123 (revised 2004)(Statement 123(R)),Share-Based Payment,
  which is a revision of FASB Statement No. 123, Accounting for Stock-Based
  Compensation (Statement 123). Statement 123(R) supersedes APB Opinion No.
  25, Accounting for Stock Issued to Employees (Opinion 25), and amends FASB
  Statement No. 95, Statement of Cash Flows. Generally, the approach in
  Statement 123(R) is similar to the approach described in Statement 123.
  However, Statement 123(R) requires all share-based payments to employees,
  including grants of employee stock options, to be recognized in the income
  statement based on their fair values. Pro forma disclosure is no longer an
  alternative. Early adoption will be permitted in periods in which financial
  statements have not yet been issued. The Company will adopt Statement 123(R)
  effective January 1, 2006.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Statement
  123(R) permits public companies to adopt its requirements using one of two
  methods:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | A modified
  prospective method in which compensation cost is recognized beginning with
  the effective date (a) based on the requirements of Statement 123(R) for all
  share-based payments granted after the effective date and (b) based on the
  requirements of Statement 123 for all awards granted to employees prior to
  the effective date of Statement 123(R) that remain unvested on the effective
  date.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | A modified
  retrospective method which includes the requirements of the modified
  prospective method described above, but also permits entities to restate
  based on the amounts previously recognized under Statement 123 for purposes
  of pro forma disclosures either (a) all prior periods presented or (b) prior
  interim periods of the year of adoption.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

F - 21

---



|                                                           |                                                      
|---------------------------------------------------------- | -----------------------------------------------------
|                                                           | ALADDIN KNOWLEDGE SYSTEMS LTD.
  AND ITS SUBSIDIARIES
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                 |                                                      
|                                                           |                                                      
|U.S. dollars in thousands, except share and per share data |                                                      

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | The Company
  plans to adopt Statement 123(R) using the modified-prospective method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | As permitted
  by Statement 123, the company currently accounts for share-based payments to
  employees using Opinion 25s intrinsic value method and, as such, generally
  recognizes no compensation cost for employee stock options. The impact of
  adoption of Statement 123(R) cannot be predicted at this time because it will
  depend on levels of share-based payments granted in the future. However, had
  the Company adopted Statement 123(R) in prior periods, the impact of that
  standard would have approximated the impact of Statement 123 as described in
  the disclosure of pro forma net income and earnings per share in Note 2 to
  the consolidated financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | In March
  2005, the SEC released SEC Staff Accounting Bulletin No. 107, Share Based
  Payment (SAB 107). SAB 107 provides the SECs staff position regarding the
  application of FAS 123(R) and contains interpretive guidance relating to the
  interaction between FAS 123(R) and certain SEC rules and regulations, and
  also provides the SEC staffs view regarding the valuation of share-based
  payment arrangements for public companies. SAB 107 highlights the importance
  of disclosures made relating to the accounting for share-based payment
  transactions. The Company is currently reviewing the effect of SAB 107;
  however it does not believe that SAB 107 will have a material effect on its
  financial position, results of operations or cash flows.                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | In November
  2005, the FASB issued FSP FAS 115-1 (FSP). The FSP addresses the
  determination as to when an investment is considered impaired, whether that
  impairment is other than temporary, and the measurement of an impairment
  loss. The FSP also includes accounting considerations subsequent to the
  recognition of other than-temporary impairment and requires certain
  disclosures about unrealized losses that have not been recognized as other-than-temporary
  impairments. The guidance in this FSP amends FASB Statements No. 115,
  Accounting for Certain Investments in Debt and Equity. The FSP replaces the
  impairment evaluation guidance of EITF Issue No. 03-1, The Meaning of
  Other-Than-Temporary Impairment and Its Application to Certain Investments,
  with references to the existing other-than-temporary impairment guidance. The
  FSP clarifies that an investor should recognize an impairment loss no later
  than when the impairment is deemed other-than-temporary, even if a decision
  to sell an impaired security has not been made. The guidance in this FSP is
  to be applied to reporting periods beginning after December 15, 2005.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | In May 2005,
  the FASB issued Statement of Financial Accounting Standard No. 154 (SFAS No.
  154), Accounting Changes and Error Corrections, a replacement of APB No.
  20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in
  Interim Financial Statements. SFAS No. 154 provides guidance on the
  accounting for and reporting of accounting changes and error corrections. APB
  No. 20 previously required that most voluntary changes in accounting
  principles be recognized by including in net income for the period of change
  the cumulative effect of changing to the new accounting principle. SFAS No.
  154 requires retroactive application to prior periods financial statements
  of a voluntary change in accounting principles unless it is impracticable.
  SFAS No. 154 is effective for accounting changes and corrections of errors
  made in fiscal years beginning after December 15, 2005.                                                                                                                                                                                                                                                  

F - 22

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                         
|-------- | ------------------------------------------------------------------------
|NOTE 3:- | MARKETABLE SECURITIES                                                   
|         |                                                                         
|         | The
  following is a summary of available-for-sale marketable securities

|                        |  |                       |       |                            |   |                             |  |                                   |    |      |   |                            |  |                             |        |                           |   |                                   |  |   |     |  |   |     |  |   |        | 
|----------------------- |  | --------------------- | ----- | -------------------------- | - | --------------------------- |  | --------------------------------- | -- | ---- | - | -------------------------- |  | --------------------------- | ------ | ------------------------- | - | --------------------------------- |  | - | --- |  | - | --- |  | - | ------ | 
|                        |  | December
  31,
  2004 |       | December
  31,
  2005      |  
|                        |  |                       |       |                            |  
|                        |  | Cost                  |       | Gross
  unrealized
  gains |   | Gross
  unrealized
  losses |  | Estimated
  fair
  market
  value |    | Cost |   | Gross
  unrealized
  gains |  | Gross
  unrealized
  losses |        | Gross
  realized
  losses |   | Estimated
  fair
  market
  value | 
|                        |  |                       |       |                            |   |                             |  |                                   |    |      |   |                            |  |                             |        |                           |   |                                   | 
|                        |  |                       |       |                            |   |                             |  |                                   |    |      |   |                            |  |                             |        |                           |   |                                   |  |   |     |  |   |     |  |   |        | 
|Government bonds        |  | $                     | 7,000 |                            | $ |                            |  | $                                 | 38 |      | $ | 6,962                      |  | $                           | 27,227 |                           | $ |                                  |  | $ | 201 |  | $ | 117 |  | $ | 26,909 | 
|Equity securities       |  |                       | 927   |                            |   | 709                         |  |                                   |   |      |   | 1,636                      |  |                             | 927    |                           |   | 479                               |  |   |    |  |   |    |  |   | 1,406  | 
|Auction rate securities |  |                       |      |                            |   |                            |  |                                   |   |      |   |                           |  |                             | 20,500 |                           |   |                                  |  |   |    |  |   |    |  |   | 20,500 | 
|                        |  |                       |       |                            |   |                             |  |                                   |    |      |   |                            |  |                             |        |                           |   |                                   |  |   |     |  |   |     |  |   |        | 
|                        |  |                       |       |                            |   |                             |  |                                   |    |      |   |                            |  |                             |        |                           |   |                                   |  |   |     |  |   |     |  |   |        | 
|                        |  | $                     | 7,927 |                            | $ | 709                         |  | $                                 | 38 |      | $ | 8,598                      |  | $                           | 48,654 |                           | $ | 479                               |  | $ | 201 |  | $ | 117 |  | $ | 48,815 | 
|                        |  |                       |       |                            |   |                             |  |                                   |    |      |   |                            |  |                             |        |                           |   |                                   |  |   |     |  |   |     |  |   |        | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In October
  2004 and July 2005, the Company invested in U.S. government bonds with
  maturities of up to four and two years, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | The net
  adjustment to unrealized gains (losses) on available-for-sale marketable
  securities was included as a separate component of shareholders equity:
  accumulated other comprehensive income (loss) and amounted to $ 260, $ 223 and
  $ (302) in 2003, 2004 and 2005, respectively.                                                                                                                                                                                                                                                                                                                                                                        
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | According to
  Staff Accounting Bulletin No. 59 (SAB No. 59) and EITF 03-1, The Meaning
  of Other-Than-Temporary Impairment and Its Application to Certain
  Investments, for any marketable securities whose value declined during the
  period, management is required to evaluate whether the decline is other than
  temporary. In 2005, a decline in value that was considered other than
  temporary of one of the Companys available-for-sale securities resulted in
  reversing the accumulated unrealized loss of $ 117 relating to these
  investments. The amount was classified as financial expenses in the
  consolidated statements of operations.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | Aggregate
  maturities of Government bonds for years subsequent to December 31, 2005 are:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

| |      |  |                  |        |                                 |   |        | 
| | ---- |  | ---------------- | ------ | ------------------------------- | - | ------ | 
| |      |  | Amortized
  cost |        | Estimated
  fair market
  value |  
| |      |  |                  |        |                                 |  
| |      |  |                  |        |                                 |   |        | 
| | 2006 |  | $                | 3,262  |                                 | $ | 3,230  | 
| | 2007 |  |                  | 23,965 |                                 |   | 23,679 | 
| |      |  |                  |        |                                 |   |        | 
| |      |  |                  |        |                                 |   |        | 
| |      |  | $                | 27,227 |                                 | $ | 26,909 | 
| |      |  |                  |        |                                 |   |        | 

F - 23

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                               
|-------- | ----------------------------------------------
|NOTE 4:- | OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES

| |                          |  |              |       |      |   |       | 
| | ------------------------ |  | ------------ | ----- | ---- | - | ----- | 
| |                          |  | December 31, |      
| |                          |  |              |      
| |                          |  | 2004         |       | 2005 |  
| |                          |  |              |       |      |  
| |                          |  |              |       |      |   |       | 
| | Loans to
  employees     |  | $            | 374   |      | $ | 191   | 
| | Prepaid
  expenses       |  |              | 1,823 |      |   | 1,877 | 
| | Government
  authorities |  |              | 788   |      |   | 955   | 
| | Advances for
  suppliers |  |              | 163   |      |   | 205   | 
| | Other                    |  |              | 298   |      |   | 289   | 
| |                          |  |              |       |      |   |       | 
| |                          |  |              |       |      |   |       | 
| |                          |  | $            | 3,446 |      | $ | 3,517 | 
| |                          |  |              |       |      |   |       | 

|         |            
|-------- | -----------
|NOTE 5:- | INVENTORIES

| |                                     |  |              |       |      |   |       | 
| | ----------------------------------- |  | ------------ | ----- | ---- | - | ----- | 
| |                                     |  | December 31, |      
| |                                     |  |              |      
| |                                     |  | 2004         |       | 2005 |  
| |                                     |  |              |       |      |  
| |                                     |  |              |       |      |   |       | 
| | Raw
  materials, parts and supplies |  | $            | 2,343 |      | $ | 3,047 | 
| | Work-in-progress                    |  |              | 796   |      |   | 1,431 | 
| | Finished
  products                 |  |              | 2,649 |      |   | 2,520 | 
| |                                     |  |              |       |      |   |       | 
| |                                     |  |              |       |      |   |       | 
| |                                     |  | $            | 5,788 |      | $ | 6,998 | 
| |                                     |  |              |       |      |   |       | 

|         |                              
|-------- | -----------------------------
|NOTE 6:- | INVESTMENT IN OTHER COMPANIES

| |                                                              |  |              |       |      |   |       | 
| | ------------------------------------------------------------ |  | ------------ | ----- | ---- | - | ----- | 
| |                                                              |  | December 31, |      
| |                                                              |  |              |      
| |                                                              |  | 2004         |       | 2005 |  
| |                                                              |  |              |       |      |  
| |                                                              |  |              |       |      |   |       | 
| | Investment
  in Tamir Fishman Ventures II, LLC (see a below) |  | $            | 5,238 |      | $ | 5,299 | 
| | Investment in IDesia (see b below)                           |  |              | 1,100 |      |   | 1,100 | 
| |                                                              |  |              |       |      |   |       | 
| |                                                              |  |              |       |      |   |       | 
| |                                                              |  | $            | 6,338 |      | $ | 6,399 | 
| |                                                              |  |              |       |      |   |       | 

| |    |                                               
| | -- | ----------------------------------------------
| | a. | Investment
  in Tamir Fishman Ventures II, LLC

| |                                                                                                                                                                                                                                                                                                                                                                                                               
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Through December 31, 2005, the Company had
        invested an aggregate amount of $ 7,241 in Tamir Fishman Ventures II,
        LLC (Tamir Fishman). The Company does not have the ability
        to exercise significant influence and therefore the investment was stated
        at cost. See also Note 12c regarding the Companys commitment to
        make additional investments in Tamir Fishman.
| |                                                                                                                                                                                                                                                                                                                                                                                                               
| | As a result of significant uncertainty over
        the future realization of the investment, during 2002, based on managements
        analysis, impairment losses were identified in the amount of $ 1,038. During 2003, 2004 and 2005, based on
      managements most recent analysis, no impairment losses have been identified.                                                                       
| |                                                                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                               

| | 
| | 

F - 24

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                      
|-------- | -------------------------------------
|NOTE 6:- | INVESTMENT IN OTHER COMPANIES (Cont.)

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | In April
  2005, as a result of two exit transactions for portfolio companies of Tamir
  Fishman, the Company received a distribution of $ 910 in cash and expects an
  additional cash distribution of $ 63 and 119,873 shares of Common stock of
  Agere Systems, Inc. (the Agere shares) based on the Agere shares price on
  the date of distribution. Approximately 15% of the distribution is held in
  escrow for approximately one year, to cover potential obligations of the portfolio
  companies to the buyers. The income from the distribution received in 2005
  was recorded as a return of investment.                                                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | b. | Investment
  in IDesia. (formerly: C-Signature Ltd.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | In April 2004, the Company entered into a convertible loan agreement
        with IDesia, an Israeli company engaged in the development of biometric
        identity recognition technology. Pursuant to the agreement, the Company
        invested an aggregate amount of $1,100 in IDesia (including expenses in
        the amount of $ 50). This investment consisted of a $ 550 convertible
        loan (the Convertible Loan), which would automatically converted
        into Series A preferred shares of IDesia upon the achievement of certain
        agreed upon milestones. Concurrently with the conversion of the loan,
        the Company invested the remaining $ 500 by purchasing additional Series
        A preferred shares of IDesia. At December 31, 2004, the Company owned
        19.9% of the share capital of IDesia and accounted for this investment
        under the cost method.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | During the fourth quarter of 2005 IDesia entered into a new Convertible
        Series A Preferred Share Purchase Agreement (the SPA) with
        a new third party investor (the Investor). At the Closing
        of the SPA, IDesia issued to the Company, for no additional consideration,
        additional Convertible Series A Preferred Shares, in such way that the
        aggregate number of Preferred Shares held by the Company at the original
        2004 investment of $ 1,050 represents 27.04% of the share capital of IDesia.                                                                                                                                                                                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | In October 2005, the Company signed a license and OEM agreement
        with IDesia. Under this agreement IDesia will develop, manufacture, provide
        and license to the Company certain Chip-Sets as specified in this agreement.
        According to the agreement the Company advanced IDesia. $ 200 in consideration
        for the Chip-Sets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

F - 25

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                            
|-------- | ---------------------------
|NOTE 7:- | PROPERTY AND EQUIPMENT, NET

| |                                    |  |                |        |      |   |        | 
| | ---------------------------------- |  | -------------- | ------ | ---- | - | ------ | 
| |                                    |  | December
  31, |       
| |                                    |  |                |       
| |                                    |  | 2004           |        | 2005 |  
| |                                    |  |                |        |      |  
| | Cost:                              |  |                |        |      |   |        | 
| | Computers and peripheral equipment |  | $              | 12,757 |      | $ | 13,136 | 
| | Office furniture and equipment     |  |                | 2,076  |      |   | 1,971  | 
| | Motor vehicles                     |  |                | 650    |      |   | 462    | 
| | Leasehold improvements             |  |                | 1,267  |      |   | 1,657  | 
| |                                    |  |                |        |      |   |        | 
| |                                    |  |                |        |      |   |        | 
| |                                    |  |                | 16,750 |      |   | 17,226 | 
| |                                    |  |                |        |      |   |        | 
| | Accumulated
  depreciation:        |  |                |        |      |   |        | 
| | Computers and peripheral equipment |  |                | 11,638 |      |   | 11,367 | 
| | Office furniture and equipment     |  |                | 1,556  |      |   | 1,453  | 
| | Motor vehicles                     |  |                | 388    |      |   | 258    | 
| | Leasehold improvements             |  |                | 934    |      |   | 1,067  | 
| |                                    |  |                |        |      |   |        | 
| |                                    |  |                |        |      |   |        | 
| |                                    |  |                | 14,516 |      |   | 14,145 | 
| |                                    |  |                |        |      |   |        | 
| |                                    |  |                |        |      |   |        | 
| | Depreciated
  cost                 |  | $              | 2,234  |      | $ | 3,081  | 
| |                                    |  |                |        |      |   |        | 

|         |                                                                                                                                       
|-------- | --------------------------------------------------------------------------------------------------------------------------------------
|         | Depreciation
  expenses for the years ended December 31, 2003, 2004 and 2005 amounted to $
  1,889, $ 1,463 and $ 1,409, respectively.
|         |                                                                                                                                       
|NOTE 8:- | INTANGIBLE ASSETS, NET                                                                                                                
|         |                                                                                                                                       
|         | a.                                                                                                                                    

| |                             |  |                |       |      |   |       | 
| | --------------------------- |  | -------------- | ----- | ---- | - | ----- | 
| |                             |  | December
  31, |      
| |                             |  |                |      
| |                             |  | 2004           |       | 2005 |  
| |                             |  |                |       |      |  
| | Cost:                       |  |                |       |      |   |       | 
| | Current technology (1)      |  | $              | 1,054 |      | $ | 1,054 | 
| | Customer list (2)           |  |                | 1,151 |      |   | 1,151 | 
| | Domain names (3)            |  |                | 930   |      |   | 930   | 
| | Patent (4)                  |  |                | 550   |      |   | 550   | 
| |                             |  |                |       |      |   |       | 
| |                             |  |                |       |      |   |       | 
| |                             |  |                | 3,685 |      |   | 3,685 | 
| |                             |  |                |       |      |   |       | 
| | Accumulated
  amortization: |  |                |       |      |   |       | 
| | Current technology (1)      |  |                | 731   |      |   | 933   | 
| | Customer list (2)           |  |                | 82    |      |   | 246   | 
| | Domain names (3)            |  |                | 80    |      |   | 223   | 
| | Patent (4)                  |  |                | 239   |      |   | 288   | 
| |                             |  |                |       |      |   |       | 
| |                             |  |                |       |      |   |       | 
| |                             |  |                | 1,132 |      |   | 1,690 | 
| |                             |  |                |       |      |   |       | 
| |                             |  |                |       |      |   |       | 
| | Amortized
  cost            |  | $              | 2,553 |      | $ | 1,995 | 
| |                             |  |                |       |      |   |       | 

| |     |                                                                                                                                                                 
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Current
  technology - is being amortized over a period of five years and will be fully
  amortized in 2006                                                     
| |     |                                                                                                                                                                 
| | (2) | Customer
  list - is being amortized over a period of seven years and will be fully
  amortized in 2011. See also Note 1b for the acquisition of Aladdin Espana.

F - 26

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                |                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|-------- | ------------------------------ | --------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 8:- | INTANGIBLE ASSETS, NET (Cont.)
|         |                                |                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                | (3)                                                                                                                               | Domain names
  - On May 27, 2004, the Company and Aladdin Systems Holdings Inc. (ASH)
  entered into a settlement agreement (the Agreement). Under the terms of the
  Agreement, the Company agreed to pay ASH $ 550 for the purchase of domain
  names and for reimbursing ASH for the cost of implementing a name change and
  a re-branding. As a result of the Agreement, the Company recorded an amount
  of $ 430 which relates to the acquired domain names, which will be amortized
  over a period of 3 years (will be fully amortized in 2007). The allocation of
  the intangible assets acquired in the Agreement was determined by the Company
  which was assisted by a third-party valuation firm. Out of the $ 550, the Company
  recorded in 2004 an amount of $ 120 as general and administrative expenses.
|         |                                |                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                |                                                                                                                                   | In November
  2004, the Company purchased the URL Aladdin.com for the amount of $ 500.
  According to management, this asset is deemed to have an indefinite useful
  life and will not be amortized.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                |                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                | (4)                                                                                                                               | Patent - is
  being amortized over its useful life and will be fully amortized in 2011: See
  also Note 12b.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                |                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         | b.                             | Amortization
  expenses for the years ended December 31, 2003, 2004 and 2005, amounted to $
  221, $ 609 and $ 558, respectively.
|         |                                |                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         | c.                             | Estimated
  amortization expenses for the next five years:                                                                       

| |                       |  |   |       | 
| | --------------------- |  | - | ----- | 
| | 2006                  |  | $ | 466   | 
| | 2007                  |  |   | 272   | 
| | 2008                  |  |   | 208   | 
| | 2009                  |  |   | 208   | 
| | 2010 and
  thereafter |  |   | 841   | 
| |                       |  |   |       | 
| |                       |  |   |       | 
| |                       |  | $ | 1,995 | 
| |                       |  |   |       | 

F - 27

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                              
|-------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 9:- | GOODWILL                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                              
|         | As fully
  discussed in Note 15, the Company operates in two operating segments which
  are also considered by management as the Companys reporting units. The
  changes in the carrying amount of goodwill for the years ended December 31,
  2004 and 2005 are as follows:

| |                                                                                         |  |                                       |       |                                 |   |       |  |   |       | 
| | --------------------------------------------------------------------------------------- |  | ------------------------------------- | ----- | ------------------------------- | - | ----- |  | - | ----- | 
| |                                                                                         |  | Software
  Security
  (DRM)
  segment |       | Enterprise
  Security
  segment |   | Total | 
| |                                                                                         |  |                                       |       |                                 |   |       | 
| |                                                                                         |  |                                       |       |                                 |   |       |  |   |       | 
| | Balance as of January 1, 2004                                                           |  | $                                     | 6,522 |                                 | $ | 759   |  | $ | 7,281 | 
| | Goodwill resulted from the acquisition of
  Aladdin Espanã, S.L. (see also Note 1b) (1) |  |                                       | 323   |                                 |   | 81    |  |   | 404   | 
| |                                                                                         |  |                                       |       |                                 |   |       |  |   |       | 
| |                                                                                         |  |                                       |       |                                 |   |       |  |   |       | 
| | Balance as of December 31, 2004                                                         |  |                                       | 6,845 |                                 |   | 840   |  |   | 7,685 | 
| |                                                                                         |  |                                       |       |                                 |   |       |  |   |       | 
| |                                                                                         |  |                                       |       |                                 |   |       |  |   |       | 
| | Balance as of December 31, 2005                                                         |  | $                                     | 6,845 |                                 | $ | 840   |  | $ | 7,685 | 
| |                                                                                         |  |                                       |       |                                 |   |       |  |   |       | 

|          |                                 |                                                                                                                                       
|--------- | ------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------
|          | (1)                             | Goodwill
  acquired was allocated to reporting units based on the expected benefits of
  the business acquired to each reporting unit.
|          |                                 |                                                                                                                                       
|NOTE 10:- | DEFERRED INCOME TAXES AND OTHER

|          |                                              |  |                |       |      |   |       | 
|--------- | -------------------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
|          |                                              |  | December
  31, |      
|          |                                              |  |                |      
|          |                                              |  | 2004           |       | 2005 |  
|          |                                              |  |                |       |      |  
|          |                                              |  |                |       |      |   |       | 
|          | Deferred
  income taxes (See Note 13)        |  | $              | 1,073 |      | $ | 1,217 | 
|          | Long-term
  prepaid expenses                 |  |                | 215   |      |   | 174   | 
|          |                                              |  |                |       |      |   |       | 
|          |                                              |  |                |       |      |   |       | 
|          |                                              |  | $              | 1,288 |      | $ | 1,391 | 
|          |                                              |  |                |       |      |   |       | 
|          |                                              |  |                |       |      |   |       | 
|NOTE 11:- | ACCRUED EXPENSES AND OTHER ACCOUNTS PAYABLES |  |                |       |      |   |       | 

| |                                  |  |                |       |      |   |       | 
| | -------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
| |                                  |  | December
  31, |      
| |                                  |  |                |      
| |                                  |  | 2004           |       | 2005 |  
| |                                  |  |                |       |      |  
| |                                  |  |                |       |      |   |       | 
| | Employees
  and payroll accruals |  | $              | 3,316 |      | $ | 4,215 | 
| | Income taxes
  payable           |  |                | 487   |      |   | 2,429 | 
| | Accrued
  expenses               |  |                | 1,971 |      |   | 1,072 | 
| | Deferred tax
  liability         |  |                | 145   |      |   | 53    | 
| | Other                            |  |                | 70    |      |   | 30    | 
| |                                  |  |                |       |      |   |       | 
| |                                  |  |                |       |      |   |       | 
| |                                  |  | $              | 5,989 |      | $ | 7,799 | 
| |                                  |  |                |       |      |   |       | 

F - 28

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                        |                                                                                                                                                                                   
|--------- | -------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 12:- | COMMITMENTS AND CONTINGENT LIABILITIES
|          |                                        |                                                                                                                                                                                   
|          | a.                                     | Lease
  commitments:                                                                                                                                                              
|          |                                        |                                                                                                                                                                                   
|          |                                        | The Company
  and its subsidiaries premises and motor vehicles are leased under various
  operating lease agreements which expire on various dates, the latest of which
  is 2011.
|          |                                        |                                                                                                                                                                                   
|          |                                        | Minimum
  lease commitments, under non-cancelable leases as of December 31, 2005, are
  as follows:                                                                               

| |                         |  |            |       |                  |   |       |  |   |       | 
| | ----------------------- |  | ---------- | ----- | ---------------- | - | ----- |  | - | ----- | 
| |                         |  | Facilities |       | Motor
  vehicles |   | Total | 
| |                         |  |            |       |                  |   |       | 
| | Year ended
December, 31 |  |            |       |                  |   |       |  |   |       | 
| | 2006                    |  | $          | 1,798 |                  | $ | 1,062 |  | $ | 2,860 | 
| | 2007                    |  |            | 1,897 |                  |   | 662   |  |   | 2,559 | 
| | 2008                    |  |            | 1,514 |                  |   | 238   |  |   | 1,752 | 
| | 2009                    |  |            | 1,492 |                  |   | 24    |  |   | 1,516 | 
| | 2010 and
  thereafter   |  |            | 1,113 |                  |   |      |  |   | 1,113 | 
| |                         |  |            |       |                  |   |       |  |   |       | 
| |                         |  |            |       |                  |   |       |  |   |       | 
| |                         |  | $          | 7,814 |                  | $ | 1,986 |  | $ | 9,800 | 
| |                         |  |            |       |                  |   |       |  |   |       | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | Facilities
  lease expenses for the years ended December 31, 2003, 2004 and 2005 were
  approximately $ 1,871, $ 1,941 and $ 1,785, respectively.                                                                                                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |    | Motor
  vehicle lease expenses for the years ended December 31, 2003, 2004 and 2005
  were approximately $ 699, $ 1,081 and $ 1,294, respectively.                                                                                                                                                                                                                                                                                                                                               
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | b. | Litigation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |    | In April
  2005, the Company settled a patent infringement lawsuit. The lawsuit was
  originally brought by Andrew Pickholtz against the Company and its U.S.
  subsidiary on May 19, 2004 in the U.S. District Court for the Northern
  District of California, alleging that the Companys discontinued MicroGuard
  product and other Software Digital Rights Management products infringed an
  expired patent. An affiliate of Rainbow Technologies was subsequently added
  as a plaintiff.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |    | On April 6,
  2005, the parties reached a settlement agreement, under which the Company
  agreed to pay $ 2,000 to settle the lawsuit. The Company recorded the
  settlement cost as a one-time charge within its operating expenses. There
  will be no ongoing license or other fees payable by the Company in connection
  with the settlement.                                                                                                                                               
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | c. | Investment
  commitment:                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |    | In February 2000, the Company signed an agreement with Tamir Fishman.
        Pursuant to the agreement, the Company committed to invest up to $8,475
        on demand from Tamir Fishman, out of which, as of December 31, 2005, the
        Company had already invested $7,241.                                                                                                                                                                                                              

F - 29

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--------- | --------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 13:- | TAXES ON INCOME
|          |                
|          | a.              | Reduction in
  Israeli tax rates:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|          |                 | Until
  December 31, 2003, the regular tax rate applicable to income of companies
  (which are not entitled to benefits due to Approved Enterprise, as
  described below) was 36%. In June 2004 and in July 2005, the Knesset
  (Israeli parliament) passed amendments to the Income Tax Ordinance (No. 140
  and Temporary Provision), 2004 and (No. 147), 2005 respectively, which
  determine, among other things, that the corporate tax rate is to be gradually
  reduced to the following tax rates: 2004 - 35%, 2005 - 34%, 2006 - 31%, 2007
  - 29%, 2008 - 27%, 2009 - 26% and 2010 and thereafter - 25%.                                                                                               
|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|          | b.              | Tax benefits
  under the Law for the Encouragement of Capital Investments, 1959 (the Law):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|          |                 | The
  Companys production facilities have been granted Approved Enterprise
  status under the Law currently under seven separate investment programs.
  Pursuant to the Law, the Company has elected the alternative benefits track
  and has waived Government grants in return for a tax exemption.                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|          |                 | The Company
  is also a foreign investors company, as defined by the Law, and, as such,
  is entitled to a 10-year period of benefits and may be entitled to reduced
  tax rates of between 10% and 25% (based on the percentage of foreign
  ownership in each taxable year).                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|          |                 | For the
  Companys seven investment programs, the tax benefits are as follows: Income
  derived from the investment programs, is tax exempt for the first two years
  of the 10-year tax benefit period, and is entitled to a reduced tax rate of
  10%-25% during the remaining benefit period (based on the percentage of
  foreign ownership in each taxable year).                                                                                                                                                                                                                                                                                                                                              
|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|          |                 | The period
  of tax benefits detailed above is subject to time limits of the earlier of 12
  years from commencement of production, or 14 years from receiving the
  approval. Accordingly, the period of benefits relating to all investment
  programs will expire in the years 2005 through 2012.                                                                                                                                                                                                                                                                                                                                                                                                                 
|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|          |                 | In 1996, the
  Company relocated its manufacturing activity to a new plant which was
  established in a region defined as a Priority A Development Region. This
  development region entitles Aladdin Israel to higher tax benefits than the
  tax benefits existing where the Companys offices and research and
  development center are located.                                                                                                                                                                                                                                                                                                                                                              
|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|          |                 | The
  allocation of the income tax between the priority regions is calculated by a
  formula that was authorized by Israel Tax Authority.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|          |                 |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|          |                 | On April 1,
  2005, an amendment to the Investment Law came into effect (the Amendment)
  and has significantly changed the provisions of the Investment Law. The
  Amendment limits the scope of enterprises which may be approved by the
  Investment Center by setting criteria for the approval of a facility as a
  Privileged Enterprise, such as provisions generally requiring that at least
  25% of the Privileged Enterprises income will be derived from export.
  Additionally, the Amendment enacted major changes in the manner in which tax
  benefits are awarded under the Investment Law so that companies no longer
  require Investment Center approval in order to qualify for tax benefits.

F - 30

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|--------- | ----------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 13:- | TAXES ON INCOME (Cont.)
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                         | However, the
  Investment Law provides that terms and benefits included in any certificate
  of approval already granted will remain subject to the provisions of the law
  as they were on the date of such approval.                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                         | As of
  December 31, 2005, retained earnings included approximately $34,520 in
  tax-exempt profits earned by the Companys Approved Enterprise. The Company
  has decided not to declare dividends out of such tax-exempt income.
  Accordingly, no deferred income taxes have been provided on income
  attributable to the Companys Approved Enterprise.                                                                                                                                                                                                                                                                                                                          
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                         | If the
  retained tax-exempt income is distributed, it would be taxed at the corporate
  tax rate applicable to such profits as if the Company had not elected the
  alternative tax benefits (10% to25%).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                         | The
  entitlement to the above benefits is conditional upon the Companys
  fulfillment of the conditions stipulated by the above law, regulations
  published thereunder and the instruments of approval for the specific
  investments in Approved Enterprises. In the event of failure to comply with
  these conditions, the benefits may be cancelled and the Company may be
  required to refund the amount of the benefits, in whole or in part, including
  interest.                                                                                                                                                                                                           
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                         | Management
  believes that as of December 31, 2005, the Company met all of the
  aforementioned conditions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                         | Income from
  sources other than the Approved Enterprise during the benefit period will
  be subject to tax at the statutory corporate tax rate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                         | Since the
  Company is operating under more than one approved program and since part of
  its taxable income is not entitled to tax benefits under the aforementioned
  law and is taxed at the statutory corporate tax rate of 34% (see also Note
  13c) its effective tax rate is the result of a weighted combination of the
  various applicable rates and tax exemptions, and the computation is made for
  income derived from each program on the basis of formulas specified in the
  law and in the approvals.                                                                                                                                                                   
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                         | By virtue of
  this law, the Company is entitled to claim accelerated depreciation on
  equipment used by the Approved Enterprise during five tax years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          | c.                      | Measurement
  of taxable income under the Income Tax (Inflationary Adjustments) Law, 1985:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                         | Results for
  tax purposes are measured and reflected in real terms in accordance with the
  change in Israels Consumer Price Index (CPI). As explained in Note 2, the
  consolidated financial statements are presented in U.S. dollars. The
  differences between the change in Israelis CPI and in the NIS/dollar
  exchange rate causes a further difference between taxable income and the
  income before taxes reflected in the consolidated financial statements. In
  accordance with paragraph 9(f) of SFAS No. 109, the Company has not
  provided deferred income taxes on the difference between the functional
  currency and the tax bases of assets and liabilities.

F - 31

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                         |                                                                                                                                                                                                                                                                                     
|--------- | ----------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 13:- | TAXES ON INCOME (Cont.)
|          |                        
|          | d.                      | Tax benefits
  under Israels Law for the Encouragement of Industry (Taxation), 1969:                                                                                                                                                                                               
|          |                         |                                                                                                                                                                                                                                                                                     
|          |                         | The Company
  is an Industrial company, as defined by the Law for the Encouragement of
  Industry (Taxes), 1969 and as such, is entitled to certain tax benefits,
  mainly amortization of costs relating to know-how and patents over eight
  years and accelerated depreciation.
|          |                         |                                                                                                                                                                                                                                                                                     
|          | e.                      | Income
  before taxes is comprised as follows:                                                                                                                                                                                                                                      

| |  |          |  |                         |       |      |   |       |  |   |        | 
| |  | -------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | ------ | 
| |  |          |  | Year ended December 31, |      
| |  |          |  |                         |      
| |  |          |  | 2003                    |       | 2004 |   | 2005  | 
| |  |          |  |                         |       |      |   |       | 
| |  |          |  |                         |       |      |   |       |  |   |        | 
| |  | Domestic |  | $                       | 1,988 |      | $ | 6,572 |  | $ | 8,809  | 
| |  | Foreign  |  |                         | 897   |      |   | 3,173 |  |   | 4,793  | 
| |  |          |  |                         |       |      |   |       |  |   |        | 
| |  |          |  |                         |       |      |   |       |  |   |        | 
| |  |          |  | $                       | 2,885 |      | $ | 9,745 |  | $ | 13,602 | 
| |  |          |  |                         |       |      |   |       |  |   |        | 

| |    |                                                                                                                        
| | -- | -----------------------------------------------------------------------------------------------------------------------
| | f. | The income
  tax provision (benefit) for the years ended December 31, 2003, 2004 and 2005
  consisted of the following:

| |  |          |  |                         |      |      |   |      |  |   |       |  
| |  | -------- |  | ----------------------- | ---- | ---- | - | ---- |  | - | ----- | -
| |  |          |  | Year ended December 31, |     
| |  |          |  |                         |     
| |  |          |  | 2003                    |      | 2004 |   | 2005 | 
| |  |          |  |                         |      |      |   |      | 
| |  |          |  |                         |      |      |   |      |  |   |       |  
| |  | Current  |  | $                       | 399  |      | $ | 957  |  | $ | 2,049 |  
| |  | Deferred |  |                         | (350 | )    |   |     |  |   | (803  | )
| |  |          |  |                         |      |      |   |      |  |   |       |  
| |  |          |  | $                       | 49   |      | $ | 957  |  | $ | 1,246 |  
| |  |          |  |                         |      |      |   |      |  |   |       |  
|
| |  | Domestic |  | $                       | 216  |      | $ | 723  |  | $ | 583   |  
| |  | Foreign  |  |                         | (167 | )    |   | 234  |  |   | 663   |  
| |  |          |  |                         |      |      |   |      |  |   |       |  
|
| |  |          |  | $                       | 49   |      | $ | 957  |  | $ | 1,246 |  
| |  |          |  |                         |      |      |   |      |  |   |       |  

F - 32

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                         |                                                                                                                                                                                                                                                                                                                     
|--------- | ----------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 13:- | TAXES ON INCOME (Cont.)
|          |                        
|          | g.                      | Deferred
  income taxes:                                                                                                                                                                                                                                                                                            
|          |                         |                                                                                                                                                                                                                                                                                                                     
|          |                         | Deferred income
  taxes reflect the net tax effects of temporary differences between the
  carrying amounts of assets and liabilities for financial reporting purposes
  and the amounts used for income tax purposes. Significant components of the
  Companys deferred tax liabilities and assets are as follows:

| |                                                                                 |  |                |        |      |   |        |  
| | ------------------------------------------------------------------------------- |  | -------------- | ------ | ---- | - | ------ | -
| |                                                                                 |  | December
  31, |       
| |                                                                                 |  |                |       
| |                                                                                 |  | 2004           |        | 2005 |  
| |                                                                                 |  |                |        |      |  
| |                                                                                 |  |                |        |      |  
| | Deferred tax assets:                                                            |  |                |        |      |   |        |  
| |                                                                                 |  |                |        |      |   |        |  
| | Reserves and allowances                                                         |  | $              | 393    |      | $ | 1,202  |  
| | Net operating loss carry forwards in
  subsidiaries                             |  |                | 9,275  |      |   | 9,127  |  
| |                                                                                 |  |                |        |      |   |        |  
| |                                                                                 |  |                |        |      |   |        |  
| | Net deferred tax assets before valuation
  allowance                            |  |                | 9,668  |      |   | 10,329 |  
| | Valuation allowance                                                             |  |                | (7,938 | )    |   | (7,953 | )
| |                                                                                 |  |                |        |      |   |        |  
| |                                                                                 |  |                |        |      |   |        |  
| | Total deferred tax assets                                                       |  |                | 1,730  |      |   | 2,376  |  
| |                                                                                 |  |                |        |      |   |        |  
| |                                                                                 |  |                |        |      |   |        |  
| | Deferred tax liability from unrealized gain
  on available- for-sale securities |  |                | (145   | )    |   | (53    | )
| |                                                                                 |  |                |        |      |   |        |  
| |                                                                                 |  |                |        |      |   |        |  
| | Total deferred tax liability                                                    |  |                | (145   | )    |   | (53    | )
| |                                                                                 |  |                |        |      |   |        |  
| |                                                                                 |  |                |        |      |   |        |  
| | Net deferred tax assets                                                         |  | $              | 1,585  |      | $ | 2,323  |  
| |                                                                                 |  |                |        |      |   |        |  
| |                                                                                 |  |                |        |      |   |        |  
| | Domestic                                                                        |  | $              | 152    |      | $ | 1,148  |  
| | Foreign                                                                         |  |                | 1,433  |      |   | 1,175  |  
| |                                                                                 |  |                |        |      |   |        |  
| |                                                                                 |  |                |        |      |   |        |  
| |                                                                                 |  | $              | 1,585  |      | $ | 2,323  |  
| |                                                                                 |  |                |        |      |   |        |  

| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | In assessing
  the realization of deferred tax assets, management considers whether it is
  more likely than not that all or some portion of the deferred tax assets will
  not be realized. The ultimate realization of the deferred tax assets is
  dependent upon the generation of future taxable income during the periods in
  which temporary differences are deductible and net operating losses are
  utilized. Based on consideration of these factors, the Company has
  established a valuation allowance of $7,938 and $7,953 at December 31,
  2004 and 2005, respectively.
| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | The
  Companys subsidiaries in the United Kingdom, Netherlands and Germany have
  estimated total available carry-forward tax losses of $1,585, $2,000 and
  $6,773, respectively, to offset against future tax profits for an indefinite
  period.                                                                                                                                                                                                                                                                                                                                     

F - 33

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                         |                                                                                                                                                                                                                                                                                                                
|--------- | ----------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 13:- | TAXES ON INCOME (Cont.)
|          |                        
|          |                         | The
  Companys subsidiaries in the United States and in France have estimated
  total available carry-forward tax losses as of December 31, 2005 of $ 15,288
  and $ 828, respectively, to offset against future tax profits for periods of
  15-20 years and five years, respectively.                       
|          |                         |                                                                                                                                                                                                                                                                                                                
|          |                         | Utilization
  of U.S. net operating losses may be subject to substantial annual limitations
  due to the change in ownership provisions of the Internal Revenue Code of
  1986 and similar state provisions. The annual limitation may result in the
  expiration of net operating losses before utilization.
|          |                         |                                                                                                                                                                                                                                                                                                                
|          | h.                      | A
  reconciliation between the theoretical tax expense, assuming all income is
  taxed at the statutory tax rate applicable to income of the Company and the
  actual tax expense as reported in the statement of income, is as follows:                                                                       

| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |       |  
| | --------------------------------------------------------------------------- | ----------------------------------------------------------------------------- | ------------------------- | ----- | ----- | - | ------ | ----- | - | ------ | ----- | -
| |                                                                             |                                                                               | Year ended
  December 31, |      
| |                                                                             |                                                                               |                           |      
| |                                                                             |                                                                               | 2003                      |       | 2004  |   | 2005   |      
| |                                                                             |                                                                               |                           |       |       |   |        |      
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |      
| | Income before taxes, as reported in the
  consolidated statements of income |                                                                               | $                         | 2,885 |       | $ | 9,745  |       | $ | 13,602 |      
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |      
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |      
| | Statutory tax rate                                                          |                                                                               |                           | 36    | %     |   | 35     | %     |   | 34     | %    
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |      
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |      
| | Expense computed at the statutory tax rate                                  |                                                                               | $                         | 1,039 |       | $ | 3,411  |       | $ | 4,625  |      
| | Decrease in taxes resulting from Approved
  Enterprise benefits (1)       |                                                                               |                           | (153  | )     |   | (353   | )     |   | (1,813 | )    
| | Tax adjustment in respect of foreign
  subsidiary different tax rate        |                                                                               |                           | 43    |       |   | 20     |       |   | 17     |      
| | Valuation allowance                                                         |                                                                               |                           |      |       |   | (284   | )     |   | 15     |      
| | Utilization of loss carry-forward                                           |                                                                               |                           | (750  | )     |   | (1,798 | )     |   | (1,261 | )    
| | Items which no deferred tax was recorded                                    |                                                                               |                           | 105   |       |   | (214   | )     |   | (918   | )    
| | Taxes in respect of prior years                                             |                                                                               |                           |      |       |   |       |       |   | 264    |      
| | Non-deductible expenses                                                     |                                                                               |                           | (235  | )     |   | 159    |       |   | 320    |      
| | Other                                                                       |                                                                               |                           |      |       |   | 16     |       |   | (3     | )    
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |      
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |      
| | Actual tax expense                                                          |                                                                               | $                         | 49    |       | $ | 957    |       | $ | 1,246  |      
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |      
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |      
| | (1)                                                                         | Per share amounts (basic) of the tax
  benefit resulting from the exemption   |                           | $     | (0.01 | ) | $      | (0.03 | ) | $      | (0.13 | )
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |       |  
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |       |  
| |                                                                             | Per share amounts (diluted) of the tax
  benefit resulting from the exemption |                           | $     | (0.01 | ) | $      | (0.03 | ) | $      | (0.12 | )
| |                                                                             |                                                                               |                           |       |       |   |        |       |   |        |       |  

F - 34

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|--------- | -------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 14:- | SHAREHOLDERS EQUITY
|          |                     
|          | a.                   | The Ordinary
  shares of the Company are quoted on The Nasdaq National Market (Nasdaq)
  under the symbol ALDN. Since July 28, 2004, the shares are also quoted
  on the Tel Aviv Stock Exchange.                                                                                                                                                                                                                                                                                                                                                                                                     
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | b.                   | The Ordinary
  shares confer upon their holders the right to receive notice to participate
  and vote in general meetings of the Company, and the right to receive
  dividends, if declared.                                                                                                                                                                                                                                                                                                                                                                                                            
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | c.                   | In October
  2001, the Company initiated a share repurchase program, in which the Company
  is authorized to purchase up to $3,000 of its outstanding Ordinary shares,
  through an open-market transaction. As of December 31, 2002, the Company
  purchased 224,100 of its outstanding Ordinary shares, at a weighted average price
  per share of $5.20. During 2004, all the shares were reissued from the share
  repurchase program.                                                                                                                                                              
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                      | Such
  repurchases of Ordinary shares are accounted for as Treasury shares, and
  result in a reduction of shareholders equity. When treasury shares are
  reissued, the Company accounts for the re-issuance in accordance with
  Accounting Principles Board Opinion No. 6 Status of Accounting Research
  Bulletins (APB No. 6) and charges the excess of the repurchase cost over
  issuance price using the weighted average method to retained earnings. In
  case the repurchase cost is lower than the issuance price, the Company
  credits the excess cost to additional paid-in capital.
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | d.                   | In March
  2005, the Company closed its secondary public offering of its Ordinary shares
  on Nasdaq. The Company issued 2,000,000 Ordinary shares, in consideration of
  approximately $38,778, net of issuance expenses in the amount of $4,127.                                                                                                                                                                                                                                                                                                                                                      
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | e.                   | As a result
  of a grant of 100,000 options to the Companys Chief Executive Officer, the
  Company recorded in 2004 deferred compensation in the amount of $153, out of
  which an amounts of $87 and $51 was recorded as compensation expenses in the
  years 2004 and 2005, respectively.                                                                                                                                                                                                                                                                                                            
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | f.                   | Employee
  Share Option Plans:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                      | Between 1993
  and 2005, the Company implemented several Employee Share Options Plans (the
  plans). Total number of options authorized for grant under the plans
  amounted to 3,273,750. As of December 31, 2005, an aggregate of 283,195
  options of the Company are still available for future grants.                                                                                                                                                                                                                                                                                           
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                      | Under the
  Companys plans, full-time employees, officers and directors of the Company
  may be granted options to acquire Ordinary shares. The options granted are at
  an exercise price that equals the fair market value of the shares at the date
  of grant. The options generally vest over a period of two to four years from
  the date of grant, and expire no later than five or ten years from the date
  of grant. Any options that are canceled or forfeited before expiration become
  available for future grants.                                                                     

F - 35

---



ALADDIN KNOWLEDGE SYSTEMS LTD.
AND ITS SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                             
|--------- | ----------------------------
|NOTE 14:- | SHAREHOLDERS EQUITY (Cont.)

| |                                                                                  
| | ---------------------------------------------------------------------------------
| | A summary of
  the Companys share option activity under the plans is as follows:

| |                                            |  |                      |           |                                       |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 
| | ------------------------------------------ |  | -------------------- | --------- | ------------------------------------- | - | ------------------- |  | ------------------------------------- | --------- | ------------------- | - | ------------------------------------- |  |  | --------- | - | - | ----- | 
| |                                            |  | 2003                 |           | 2004                                  |   | 2005                | 
| |                                            |  |                      |           |                                       |   |                     | 
| |                                            |  | Number 
  of options |           | Weighted
  average
  exercise
  price |   | Number
  of options |  | Weighted
  average
  exercise
  price |           | Number
  of options |   | Weighted
  average
  exercise
  price | 
| |                                            |  |                      |           |                                       |   |                     |  |                                       |           |                     |   |                                       | 
| | Outstanding - beginning of the year        |  |                      | 1,683,400 |                                       | $ | 3.62                |  |                                       | 1,938,195 |                     | $ | 3.73                                  |  |  | 1,072,454 |   | $ | 5.57  | 
| | Granted                                    |  |                      | 638,150   |                                       | $ | 4.80                |  |                                       | 157,100   |                     | $ | 15.10                                 |  |  | 230,950   |   | $ | 20.33 | 
| | Exercised                                  |  |                      | (151,480  | )                                     | $ | 3.01                |  |                                       | (940,234  | )                   | $ | 3.91                                  |  |  | (139,527  | ) | $ | 3.48  | 
| | Forfeited                                  |  |                      | (231,875  | )                                     | $ | 5.51                |  |                                       | (82,607   | )                   | $ | 3.68                                  |  |  | (74,671   | ) | $ | 7.80  | 
| |                                            |  |                      |           |                                       |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 
| |                                            |  |                      |           |                                       |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 
| | Outstanding - end of the year              |  |                      | 1,938,195 |                                       | $ | 3.73                |  |                                       | 1,072,454 |                     | $ | 5.57                                  |  |  | 1,089,206 |   | $ | 8.81  | 
| |                                            |  |                      |           |                                       |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 
| |                                            |  |                      |           |                                       |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 
| | Options exercisable at the end of the year |  |                      | 1,023,583 |                                       | $ | 4.15                |  |                                       | 453,712   |                     | $ | 3.22                                  |  |  | 588,519   |   | $ | 4.39  | 
| |                                            |  |                      |           |                                       |   |                     |  |                                       |           |                     |   |                                       |  |  |           |   |   |       | 

| |                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Weighted
  average fair value of options whose exercise price is greater than, equal to
  or lower than the market price of the shares at date of grant are as follows:

| |                                         |  | Weighted average fair value of 
        options granted at an exercise price |     
| | --------------------------------------- |  | ---------------------------------------------------------------------------- | ----
| |                                         |  |                                                                              |     
| |                                         |  | 2003                                                                         |     
| |                                         |  |                                                                              |     
| |                                         |  |                                                                              |     
| | Equals fair
  value at date of grant    |  | $                                                                            | 2.46
| |                                         |  |                                                                              |     
| |                                         |  |                                                                              |     
| | Less than
  fair value at date of grant |  | $                                                                            | 1.82
| |                                         |  |                                                                              |     

| |                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------
| | The options
  outstanding as of December 31, 2005, have been separated into exercise price
  categories, as follows:

| |                             |                 |                                                     |  |                                                             |  |                                       |   |                                                     |   |                                                                  |  |  |         |  |   |       | 
| | --------------------------- | --------------- | --------------------------------------------------- |  | ----------------------------------------------------------- |  | ------------------------------------- | - | --------------------------------------------------- | - | ---------------------------------------------------------------- |  |  | ------- |  | - | ----- | 
| | Range of
  exercise
  price |                 | Options
  outstanding
  as of
  December 31,
  2005 |  | Weighted
  average
  remaining
  contractual
  life (years) |  | Weighted
  average
  exercise
  price |   | Options
  exercisable
  as of
  December 31,
  2005 |   | Weighted
  average
  exercise
  price of
  options
  exercisable | 
| |                             |                 |                                                     |  |                                                             |  |                                       |   |                                                     |   |                                                                  | 
| | $                           | 1.20-2.67       |                                                     |  | 393,118                                                     |  |                                       | 5 |                                                     | $ | 1.83                                                             |  |  | 319,281 |  | $ | 1.91  | 
| | $                           | 3.50-4.80       |                                                     |  | 158,988                                                     |  |                                       | 5 |                                                     | $ | 4.43                                                             |  |  | 142,413 |  | $ | 4.39  | 
| | $                           | 8.51
  - 8.52   |                                                     |  | 168,500                                                     |  |                                       | 8 |                                                     | $ | 8.51                                                             |  |  | 85,850  |  | $ | 8.51  | 
| | $                           | 13.05-15.50     |                                                     |  | 143,150                                                     |  |                                       | 9 |                                                     | $ | 15.05                                                            |  |  | 38,475  |  | $ | 14.94 | 
| | $                           | 16.23
  - 24.27 |                                                     |  | 225,450                                                     |  |                                       | 9 |                                                     | $ | 20.32                                                            |  |  | 2,500   |  | $ | 18.00 | 
| |                             |                 |                                                     |  |                                                             |  |                                       |   |                                                     |   |                                                                  |  |  |         |  |   |       | 
| |                             |                 |                                                     |  |                                                             |  |                                       |   |                                                     |   |                                                                  |  |  |         |  |   |       | 
| |                             |                 |                                                     |  | 1,089,206                                                   |  |                                       |   |                                                     | $ | 8.81                                                             |  |  | 588,519 |  | $ | 4.39  | 
| |                             |                 |                                                     |  |                                                             |  |                                       |   |                                                     |   |                                                                  |  |  |         |  |   |       | 

F - 36

---



ALADDIN KNOWLEDGE SYSTEMS LTD.
AND ITS SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                    
|--------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 14:- | SHAREHOLDERS EQUITY (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                    
|          | g.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | Dividends:                                                                                                                                                                         
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                    
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | In the event
  that cash dividends are declared in the future, such dividends will be paid
  in NIS. The Company does not intend to pay cash dividends in the foreseeable
  future.
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                    
|NOTE 15:- | SEGMENTS OF THE COMPANY AND RELATED INFORMATION                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                    
|          | Commencing
  January 2004, the Company has two reportable segments related to continuing
  operations. The Software Security Digital Rights Management (DRM) Division
  develops and markets the following products: HASP HL and HASP NET,
  hardware-based software security systems, and HASP SL, a software marketing,
  licensing and distribution platform. Both the software and the hardware
  products allow software publishers to manage licensing and distribution of
  their software theft and piracy.
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                    
|          | The
  Enterprise Security Division develops and markets the USB-based eToken
  hardware device for user authentication and the eSafe line of content
  security solutions that protect PCs and networks against viruses, worms, spam
  and non-productive Internet-born content.                                                                                                                                                                                                                                   
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                    
|          | Until 2004,
  the Companys Chief Operation Decision Maker (the CODM) who is the Chief
  Executive Officer, reviewed financial information by revenues only since discrete
  financial information was not available at that time. During 2004, the
  Company started to produce discrete operating results and as a result the
  CODM began reviewing the results of the Companys business by the above
  mentioned segments.                                                                                  
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                                                    
|          | The segments
  are managed separately because each segment requires different technology and
  marketing strategies. The Software Security (DRM) Division and Enterprise
  Security Division include some international sales mainly to the United
  States, Europe, and Japan.                                                                                                                                                                                                                                    

F - 37

---



ALADDIN KNOWLEDGE SYSTEMS LTD.
AND ITS SUBSIDIARIES

|                                                          
|----------------------------------------------------------
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                        
|--------- | -------------------------------------------------------
|NOTE 15:- | SEGMENTS OF THE COMPANY AND RELATED INFORMATION (Cont.)

| |    |                                                                                                               
| | -- | --------------------------------------------------------------------------------------------------------------
| | a. | The
  following presents segment results of operations for the years ended December
  31, 2003, 2004 and 2005:

| |                                            |  |                           |         |      |   |        |   |   |        |  
| | ------------------------------------------ |  | ------------------------- | ------- | ---- | - | ------ | - | - | ------ | -
| |                                            |  | Year ended
  December 31, |        
| |                                            |  |                           |        
| |                                            |  | 2003                      |         | 2004 |   | 2005   |  
| |                                            |  |                           |         |      |   |        |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| | Revenues from external customers:          |  |                           |         |      |   |        |   |   |        |  
| | Software security (DRM)                    |  | $                         | 43,521  |      | $ | 50,650 |   | $ | 56,578 |  
| | Enterprise security                        |  |                           | 11,204  |      |   | 18,471 |   |   | 25,195 |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| | Consolidated revenues                      |  | $                         | 54,725  |      | $ | 69,121 |   | $ | 81,773 |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| | Gross profit:                              |  |                           |         |      |   |        |   |   |        |  
| | Software security (DRM)                    |  | $                         | 35,526  |      | $ | 41,109 |   | $ | 46,708 |  
| | Enterprise security                        |  |                           | 9,400   |      |   | 14,231 |   |   | 18,094 |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| |                                            |  | $                         | 44,926  |      | $ | 55,340 |   | $ | 64,802 |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| | Operating income:                          |  |                           |         |      |   |        |   |   |        |  
| | Software security (DRM)                    |  | $                         | 12,988  |      | $ | 17,779 |   | $ | 20,501 |  
| | Enterprise security                        |  |                           | (10,578 | )    |   | (7,949 | ) |   | (7,951 | )
| |                                            |  |                           |         |      |   |        |   |   |        |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| | Consolidated operating income              |  | $                         | 2,410   |      | $ | 9,830  |   | $ | 12,550 |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| | Depreciation and amortization:             |  |                           |         |      |   |        |   |   |        |  
| | Software security (DRM)                    |  | $                         | 1,423   |      | $ | 1,304  |   | $ | 1,176  |  
| | Enterprise security                        |  |                           | 687     |      |   | 768    |   |   | 791    |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| |                                            |  |                           |         |      |   |        |   |   |        |  
| | Consolidated depreciation and amortization |  | $                         | 2,110   |      | $ | 2,072  |   | $ | 1,967  |  
| |                                            |  |                           |         |      |   |        |   |   |        |  

F - 38

---



ALADDIN KNOWLEDGE SYSTEMS LTD.AND ITS SUBSIDIARIES


|                                                          
|----------------------------------------------------------
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|--------- | ------------------------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 15:- | SEGMENTS OF THE COMPANY AND RELATED INFORMATION (Cont.)
|          |                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|          | b.                                                      | The Company
  does not allocate assets to its reportable segments, as assets generally are
  not specifically attributable to any particular segment. Accordingly, asset
  information by reportable segment is not presented. Where the underlying
  assets can be specifically attributed to a segment, the related depreciation
  and amortization have been classified accordingly. The remaining depreciation
  is allocated based on a percentage of revenue. Total revenues are attributed
  to geographic areas based on the location of customers:

| |                                                  |  |                         |        |      |   |        |  |   |        | 
| | ------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
| |                                                  |  | Year ended December 31, |       
| |                                                  |  |                         |       
| |                                                  |  | 2003                    |        | 2004 |   | 2005   | 
| |                                                  |  |                         |        |      |   |        | 
| | Revenues from sales to unaffiliated
  customers: |  |                         |        |      |   |        |  |   |        | 
| | Israel                                           |  | $                       | 2,025  |      | $ | 2,381  |  | $ | 2,927  | 
| | United States                                    |  |                         | 17,621 |      |   | 19,721 |  |   | 26,789 | 
| | Europe (excluding Germany)                       |  |                         | 13,826 |      |   | 18,724 |  |   | 21,471 | 
| | Germany                                          |  |                         | 12,124 |      |   | 15,384 |  |   | 17,129 | 
| | Japan                                            |  |                         | 6,780  |      |   | 9,212  |  |   | 9,345  | 
| | Others                                           |  |                         | 2,349  |      |   | 3,699  |  |   | 4,112  | 
| |                                                  |  |                         |        |      |   |        |  |   |        | 
| |                                                  |  |                         |        |      |   |        |  |   |        | 
| |                                                  |  | $                       | 54,725 |      | $ | 69,121 |  | $ | 81,773 | 
| |                                                  |  |                         |        |      |   |        |  |   |        | 
| |                                                  |  |                         |        |      |   |        |  |   |        | 
| | Long-lived assets:                               |  |                         |        |      |   |        |  |   |        | 
| | Israel                                           |  | $                       | 6,009  |      | $ | 7,200  |  | $ | 7,638  | 
| | United States                                    |  |                         | 2,983  |      |   | 2,632  |  |   | 2,605  | 
| | Germany                                          |  |                         | 325    |      |   | 263    |  |   | 210    | 
| | Europe (excluding Germany)                       |  |                         | 719    |      |   | 2,146  |  |   | 2,048  | 
| | Japan                                            |  |                         | 223    |      |   | 231    |  |   | 260    | 
| |                                                  |  |                         |        |      |   |        |  |   |        | 
| |                                                  |  |                         |        |      |   |        |  |   |        | 
| |                                                  |  | $                       | 10,259 |      | $ | 12,472 |  | $ | 12,761 | 
| |                                                  |  |                         |        |      |   |        |  |   |        | 

| |    |                                                                                             
| | -- | --------------------------------------------------------------------------------------------
| | c. | Total
  revenues from outside customers are distributed among the following product
  lines:

| |             |  |                         |        |      |   |        |  |   |        | 
| | ----------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
| |             |  | Year ended December 31, |       
| |             |  |                         |       
| |             |  | 2003                    |        | 2004 |   | 2005   | 
| |             |  |                         |        |      |   |        | 
| |             |  |                         |        |      |   |        |  |   |        | 
| | HASP tokens |  | $                       | 41,217 |      | $ | 49,707 |  | $ | 55,969 | 
| | eSafe       |  |                         | 7,662  |      |   | 10,911 |  |   | 11,162 | 
| | eToken      |  |                         | 3,542  |      |   | 7,560  |  |   | 14,032 | 
| | Others      |  |                         | 2,304  |      |   | 943    |  |   | 610    | 
| |             |  |                         |        |      |   |        |  |   |        | 
| |             |  |                         |        |      |   |        |  |   |        | 
| |             |  | $                       | 54,725 |      | $ | 69,121 |  | $ | 81,773 | 
| |             |  |                         |        |      |   |        |  |   |        | 

F - 39

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                        |                         
|--------- | -------------------------------------- | ------------------------
|NOTE 16:- | SELECTED STATEMENTS OF OPERATIONS DATA
|          |                                        |                         
|          | a.                                     | Financial
  income, net:

| |                                                          |  |                         |      |      |   |      |   |   |        |  
| | -------------------------------------------------------- |  | ----------------------- | ---- | ---- | - | ---- | - | - | ------ | -
| |                                                          |  | Year ended December 31, |     
| |                                                          |  |                         |     
| |                                                          |  | 2003                    |      | 2004 |   | 2005 |  
| |                                                          |  |                         |      |      |   |      |  
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| | Financial
  income:                                      |  |                         |      |      |   |      |   |   |        |  
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| | Interest on marketable securities                        |  | $                       |     |      | $ | 25   |   | $ | 616    |  
| | Interest                                                 |  |                         | 161  |      |   | 370  |   |   | 1,244  |  
| | Gain from derivative instruments                         |  |                         |     |      |   |     |   |   | 456    |  
| | Foreign currency transaction differences                 |  |                         | 538  |      |   | 140  |   |   |       |  
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| |                                                          |  |                         | 699  |      |   | 535  |   |   | 2,316  |  
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| | Financial
  expenses:                                    |  |                         |      |      |   |      |   |   |        |  
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| | Impairment of available-for-sale marketable
  securities |  |                         |     |      |   |     |   |   | (117   | )
| | Loss from derivative instruments                         |  |                         |     |      |   | (234 | ) |   |       |  
| | Foreign currency transaction differences                 |  |                         |     |      |   |     |   |   | (993   | )
| | Other                                                    |  |                         | (219 | )    |   | (248 | ) |   | (168   | )
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| |                                                          |  |                         | (219 | )    |   | (482 | ) |   | (1,278 | )
| |                                                          |  |                         |      |      |   |      |   |   |        |  
| |                                                         
| |                                                          |  | $                       | 480  |      | $ | 53   |   | $ | 1,038  |  
| |                                                          |  |                         |      |      |   |      |   |   |        |  

F - 40

---



ALADDIN KNOWLEDGE SYSTEMS LTD.
AND ITS SUBSIDIARIES

|                                          
|------------------------------------------
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                                          
|U.S. dollars in thousands                 

|          |                                                |                                                                                                 | 
|--------- | ---------------------------------------------- | ----------------------------------------------------------------------------------------------- | 
|NOTE 16:- | SELECTED STATEMENTS OF OPERATIONS DATA (Cont.)
|          |                                                |                                                                                                 | 
|          | b.                                             | Net earnings
  per share:                                                                      
|          |                                                |                                                                                                 | 
|          |                                                | The
  following table sets forth the computation of basic and diluted net earnings
  per share:

| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| | -- | ----------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
| |    |                                                                                                                   |  | Year ended December 31, |       
| |    |                                                                                                                   |  |                         |       
| |    |                                                                                                                   |  | 2003                    |        | 2004 |   | 2005   | 
| |    |                                                                                                                   |  |                         |        |      |   |        | 
| | 1. | Numerator:                                                                                                        |  |                         |        |      |   |        |  |   |        | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    | Net income                                                                                                        |  | $                       | 2,736  |      | $ | 8,788  |  | $ | 12,356 | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    | Numerator for basic and diluted net
  earnings per share                                                          |  | $                       | 2,736  |      | $ | 8,788  |  | $ | 12,356 | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| | 2. | Denominator:                                                                                                      |  |                         |        |      |   |        |  |   |        | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    | Weighted average number of shares                                                                                 |  |                         | 11,477 |      |   | 11,940 |  |   | 13,899 | 
| |    | Weighted average number of treasury shares                                                                        |  |                         | (190   | )    |   |       |  |   |       | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    | Denominator for basic net earnings per
  share                                                                    |  |                         | 11,287 |      |   | 11,940 |  |   | 13,899 | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    | Effect of dilutive securities:                                                                                    |  |                         |        |      |   |        |  |   |        | 
| |    | Employee stock options                                                                                            |  |                         | 663    |      |   | 1,060  |  |   | 681    | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    | Dilutive potential Ordinary shares                                                                                |  |                         | 663    |      |   | 1,060  |  |   | 681    | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
| |    | Denominator for diluted net earnings per
  share - adjusted weighted average shares, assuming exercise of options |  |                         | 11,950 |      |   | 13,000 |  |   | 14,580 | 
| |    |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 

F - 41

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