**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **WASHINGTON,
        D.C. 20549**
 
 **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, 2007****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)**Israel**
                (Jurisdiction
                  of incorporation or organization)
                
                **35
                  Efal Street, Kiryat Arye, Petach Tikva 49511, Israel**
                (Address
                  of principal executive offices)**Aviram
                  Shemer, Chief Financial Officer**
                **Aladdin
                  Knowledge Systems Ltd., 35 Efal Street, Kiryat Arye, Petach Tikva
                  49511,
                  Israel**
                **Tel
                  (972) 3-978-1207,****Fax
                  (972) 3-978-1010**
                (Name,
                  Telephone, E-mail and/or Facsimile number and Address of Company
                  Contact
                  Person)**Securities
                  registered or to be registered pursuant to Section 12(b) of the
                  Act:**
                Ordinary
                  Shares, nominal value NIS 0.01 per share
                (Class
                  of Securities)
                
                Nasdaq
                  Global Market
                (Name
                  of Exchange)
                
                **Securities
                  registered or to be registered pursuant to Section 12(g) of the
                  Act:**
                None
                (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, 2007:14,786,187
                  Ordinary Shares
  
  Indicate
                  by check mark if the registrant is a well-known seasoned issuer,
                  as
                  defined in Rule 405 of the Securities Act.
                £YesxNoIf
                  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.
                £YesxNoIndicate
                  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£NoIndicate
                  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.
  £Large Accelerated Filer
              x Accelerated
                  Filer
              £Non-Accelerated Filer
  Indicate
                  by check mark which basis of accounting the registrant has used
                  to prepare
                  the financial statements included in this filing:
                
                US
                  GAAPx
                
                International
                  Financial Reporting Standards as issued by the International Accounting
                  Standards Board ̈
                
                Other ̈
                
                Indicate
                  by check mark which financial statement item the registrant has
                  elected to
                  follow.
                
                Item
                  17£Item
                  18 xIf
                  “Other” has been checked in response to the previous question, indicate
                  by
                  check mark which financial statement item the registrant has elected
                  to
                  follow.
                
                Item
                  17£Item
                  18 ̈
                
                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).
                
                £Yes   xNo
  
  **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 Reform 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 annual report 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;*
  ·
              *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.*
  
 
 **TABLE
        OF CONTENTS**
  PART
                    I.
                
                
                
                1Item
                    1.
                
                IDENTITY
                    OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS
                
                1Item
                    2.
                
                OFFER
                    STATISTICS AND EXPECTED TIMETABLE
                
                1Item
                    3.
                
                KEY
                    INFORMATION
                
                1Item
                    4.
                
                INFORMATION
                    ON THE COMPANY
                
                12Item
                    4A.
                
                UNRESOLVED
                    STAFF COMMENTS
                
                27Item
                    5.
                
                OPERATING
                    AND FINANCIAL REVIEW AND PROSPECTS
                
                27Item
                    6.
                
                DIRECTORS,
                    SENIOR MANAGEMENT AND EMPLOYEES
                
                42Item
                    7.
                
                MAJOR
                    SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
                
                48Item
                    8.
                
                FINANCIAL
                    INFORMATION
                
                50Item
                    9.
                
                THE
                    OFFER AND LISTING
                
                51Item
                    10.
                
                ADDITIONAL
                    INFORMATION
                
                53Item
                    11.
                
                QUANTITATIVE
                    AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
                
                64Item
                    12.
                
                DESCRIPTION
                    OF SECURITIES OTHER THAN EQUITY SECURITIES
                
                65PART
                    II.
                
                
                
                65Item
                    13.
                
                DEFAULTS,
                    DIVIDEND ARREARAGES AND DELINQUENCIES
                
                65Item
                    14.
                
                MATERIAL
                    MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF
                    PROCEEDS
                
                65Item
                    15.
                
                CONTROLS
                    AND PROCEDURES
                
                66Item
                    16A.
                
                AUDIT
                    COMMITTEE FINANCIAL EXPERT
                
                66Item
                    16B.
                
                CODE
                    OF ETHICS
                
                67Item
                    16C.
                
                PRINCIPAL
                    ACCOUNTANT FEES AND SERVICES
                
                67Item
                    16D.
                
                EXEMPTIONS
                    FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
                
                68Item
                    16E.
                
                PURCHASES
                    OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED
                    PURCHASERS
                
                68PART
                    III.
                
                
                
                68Item
                    17.
                
                FINANCIAL
                    STATEMENTS
                
                68Item
                    18.
                
                FINANCIAL
                    STATEMENTS
                
                68Item
                    19.
                
                EXHIBITS
                
                69
  
  **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, 2005, 2006 and 2007, and the selected
        consolidated balance sheet data as of December 31, 2006 and 2007, 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, 2003 and 2004 and the selected consolidated balance sheet
        data as of December 31, 2003, 2004 and 2005 from audited consolidated financial
        statements that are not included in this annual report. 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, referred
        to
        as 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. See Notes 2 and 16 to our
        consolidated financial statements for an explanation regarding the computation
        of basic and diluted net earnings per ordinary share.


**Year
                    ended December 31,**2003
                
                2004
                
                2005
                
                2006
                
                2007(In
                    thousands, except earnings per share data)**Consolidated
                    statement of operations data:**Revenues:Software
                    security
                
                $
                43,521
                
                $
                50,650
                
                $
                56,578
                
                $
                60,556
                
                $
                66,097Enterprise
                    security
                
                
                11,204
                
                
                18,471
                
                
                25,195
                
                
                28,482
                
                
                37,785Revenues
                    related to educational products
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                2,000Total
                    revenues
                
                
                54,725
                
                
                69,121
                
                
                81,773
                
                
                89,038
                
                
                105,882Cost
                    of revenues:Software
                    security
                
                
                7,995
                
                
                9,541
                
                
                9,870
                
                
                9,292
                
                
                11,745Enterprise
                    security
                
                
                1,804
                
                
                4,240
                
                
                7,101
                
                
                10,721
                
                
                13,077Cost
                    related to educational products
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                2,508
                1Total
                    cost of revenues
                
                
                9,799
                
                
                13,781
                
                
                16,971
                
                
                20,013
                
                
                27,330Gross
                    profit
                
                
                44,926
                
                
                55,340
                
                
                64,802
                
                
                69,025
                
                
                78,552Operating
                    expenses:Research
                    and development
                
                
                12,759
                
                
                12,028
                
                
                12,131
                
                
                14,336
                
                
                18,384Selling
                    and marketing
                
                
                22,012
                
                
                24,677
                
                
                26,952
                
                
                28,703
                
                
                33,194General
                    and administrative
                
                
                7,745
                
                
                8,805
                
                
                11,169
                
                
                12,780
                
                
                13,063Settlement
                    charge
                
                
                —
                
                
                —
                
                
                2,000
                
                
                —
                
                
                —Total
                    operating expenses
                
                
                42,516
                
                
                45,510
                
                
                52,252
                
                
                55,819
                
                
                64,641Operating
                    income
                
                
                2,410
                
                
                9,830
                
                
                12,550
                
                
                13,206
                
                
                13,911Financial
                    income, net
                
                
                480
                
                
                53
                
                
                1,038
                
                
                3,240
                
                
                4,274Other
                    income (expenses), net
                
                
                (5
                )
                
                (138
                )
                
                14
                
                
                284
                
                
                14Income
                    before taxes on income
                
                
                2,885
                
                
                9,745
                
                
                13,602
                
                
                16,730
                
                
                18,199Taxes
                    on income
                
                
                49
                
                
                957
                
                
                1,246
                
                
                2,699
                
                
                2,768Income
                    before equity in losses of an affiliate
                
                
                2,836
                
                
                8,788
                
                
                12,356
                
                
                14,031
                
                
                15,431Equity
                    in losses of an affiliate
                
                
                (100
                )
                
                —
                
                
                —
                
                
                —
                
                
                (543
                )Net
                    income
                
                $
                2,736
                
                $
                8,788
                
                $
                12,356
                
                $
                14,031
                
                $
                14,888Earnings
                    per share:Basic
                
                $
                0.24
                
                $
                0.74
                
                $
                0.89
                
                $
                0.96
                
                $
                1.04Diluted
                
                $
                0.23
                
                $
                0.68
                
                $
                0.85
                
                $
                0.93
                
                $
                1.02Weighted
                    average number of shares used in computing earnings per
                    share:Basic
                
                
                11,287
                
                
                11,940
                
                
                13,899
                
                
                14,596
                
                
                14,257Diluted
                
                
                11,950
                
                
                13,000
                
                
                14,580
                
                
                15,078
                
                
                14,663
  1 We have
            accumulated a total amount of approximately $2.5 million of direct expenses
            for
            developing and producing video based training materials with regard to
            a certain
            tender in which we participated. This amount was fully expensed in 2007
            since
            changes in circumstances indicated that the carrying amount of this asset
            may
            not be recoverable beyond the related revenues already recognized in
            2007.
  2
  **December
                    31,**2003
                
                2004
                
                2005
                
                2006
                
                2007**(In
                    thousands)****Consolidated
                    balance sheet data:**Cash,
                    cash equivalents and marketable securities
                
                $
                19,516
                
                $
                25,911
                
                $
                77,241
                
                $
                90,881
                
                $
                90,336Working
                    capital
                
                
                26,625
                
                
                34,111
                
                
                84,974
                
                
                100,525
                
                
                104,047Total
                    assets
                
                
                55,468
                
                
                70,894
                
                
                125,878
                
                
                148,524
                
                
                150,050Total
                    liabilities
                
                
                14,512
                
                
                17,457
                
                
                21,141
                
                
                25,875
                
                
                30,820Share
                    capital and additional paid-in capital
                
                
                36,184
                
                
                39,735
                
                
                78,998
                
                
                82,483
                
                
                84,083Shareholders’
                    equity
                
                
                40,956
                
                
                53,437
                
                
                104,737
                
                
                122,649
                
                
                119,230
  **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. and the software business unit of Macrovision Corporation,
        which
        is being sold to a private equity firm. Our competitors in the authentication
        market are 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 2007 together
        accounted for over 60% of global revenues in this market as well as a large
        number of smaller companies. While
        a
        substantial part of the products marketed by these companies provide primarily
        desktop or network solutions and not the gateway solution offered by eSafe, we
        face
        competition from some gateway solutions provided by these companies. In
        addition, some vendo rs
        of
        firewalls offering gateway security products 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 and all of our profits 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 and all of out profits
        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
        and profits from this segment for the foreseeable future. Since our software
        DRM
        products target the software industry, sales reflect trends in the software
        business cycle. Demand for our software DRM products is driven, to some extent,
        by end-user demand for software applications. If software vendors experience
        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.
  3
  **Sales
        of our products at low gross margins may adversely affect our results of
        operations.**
  In
        order
        to penetrate emerging markets, from time to time we conclude transactions
        at low
        gross margins. For example, in 2006 and 2007, we entered into several
        transactions in the Asia-Pacific region that were conducted at low gross
        margins
        in order to increase our market share in the region. In addition, we recently
        entered into some large contracts that had low gross margins. Naturally,
        as the
        scope of the transaction increases, the gross margin in such transaction
        is
        expected to decrease. We anticipate that our gross margin from enterprise
        security will decrease as we enter into an increasing number of large scale
        contracts. If we continue to enter into transactions at low gross margins
        which
        do not generate such amount of revenues which compensate us for the low gross
        margin, our results of operations could be adversely affected **.**
  **We
        rely on a limited number of source suppliers for certain 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
        a
        limited number of source suppliers. In particular, we obtain from certain
        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 third parties pursuant to license
        agreements that expire on December 31, 2008 but automatically renew for
        unlimited successive one-year periods subject to either party’s request to
        terminate at the end of each year. We would need to seek an alternative licensor
        and service provider for these functions if these third parties cease to
        provide
        these services or decide not to extend the licenses. 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 the measures
        taken by us would adequately protect us from component shortages and 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 with software DRM solutions. A change in preference towards
        software-based solutions could materially adversely affect the sales of our
        HASP
        HL token-based products, which represented ****** approximately
        62% of our total revenues in 2007.
  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 HASP HL 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 are involved in an initiative
        to implement “trusted computing” functions which may replicate some of the
        features of our software DRM products. In particular, Microsoft Corporation
        is
        developing 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.
  4
  Software
        developers are continuously adding security features to new versions of their
        software that are designed to limit intrusions by unauthorized users or viruses
        and spyware via the Internet. Microsoft has announced an anti-virus service
        geared towards consumers as well as a new strategy for anti-virus protection
        for
        businesses. In addition, the new version of Windows (Vista) has 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 and content security
        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.
 
 **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 represents 24% of our revenues. Much of this growth
        will depend on our ability to develop enhanced solutions and technologies
        for
        authentication and gain market acceptance for our product offerings, such
        as USB
        based authentication and OTP. We cannot assure you that the market will continue
        to accept our eToken products as superior to other existing technologies.
        If
        this market does not grow as projected, or if our research and development
        activities and 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 encounter difficulties in penetrating new markets for our new authentication
        products and as a result may incur increased operating expenses which may
        directly harm our operating results.**
 
 In
        the
        past few years, we have been developing additional solutions and technologies
        in
        order to enhance our eToken product line. We have a limited experience in
        introducing these tools to the market. Most of the solutions we offer to
        our
        customers are based on tools that share a common generic technology and
        methodology. However, the introduction of new tools to new markets involves
        increased selling and marketing expenses, which in turn increases our operating
        expenses and directly affects our results of operations. Because of our limited
        experience in the markets for our new authentication products, we cannot
        assure
        you that our strategy for operating in these markets or selling these products
        will be successful.
  **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.
  5
  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 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 2005, we reached a settlement with respect
        to
        this claim. 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. A successful
        claim of product infringement against us and our failure or inability to
        license
        the infringed or similar technology could have a material adverse effect
        on our
        business, financial condition and results of operations.
  **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;
  ·
              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 patents and certain 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.
  6
  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 2007, 44% of our revenues were generated
        from 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.
  The
        termination or loss of significant customer agreements could have a significant
        impact on our results of operations. Although we have not had a customer
        which
        accounted for more than 10% of our revenues in any of the past three years,
        from
        time to time we may enter into significant customer contracts, the termination,
        non-renewal or other loss of which would have a significant impact on our
        quarterly or annual results of operations.
  7
  **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 and the majority of our revenues
        are
        generated in dollars, a significant portion of our revenues and expenses
        in
        certain locations are denominated in currencies other than the dollar including,
        in particular, the euro. In periods when the U.S. dollar changes 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.
  **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 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 that our products provide
        in
        order to penetrate and harm our customers’ networks. Failure to provide
        effective content security solutions could seriously harm our business.
  8
  **Acquisitions
        could result in dilution, operating difficulties and other adverse consequences.**
  During
        the last decade, 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. In addition, to the extent that we pursue acquisition opportunities
        which are not consummated, we may incur substantial out-of-pocket expenses
        without any associated benefit.
  **If
        we do not comply with European governmental regulations setting environmental
        standards, we may be restricted from selling our products in the European
        Union.
        In addition, complying with these standards involve financial costs.**
  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, requires that certain of our products be modified to
        meet
        this regulation. 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, known 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. We may incur financial responsibility for the collection, recycling,
        treatment or disposal of products covered under the WEEE Directive. 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 additional reserves for costs associated with compliance
        with
        these regulations.
  9
  ***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 2007, the price of our ordinary shares
        on The Nasdaq Global Market fluctuated between $16.83 and $26.57 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 19.94% of our outstanding ordinary
        shares. Messrs. Jacob and Dany Margalit are brothers, and both sit on our
        board
        of directors which comprises a total of five members. Accordingly, they have
        significant 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 Global Market and the Tel Aviv Stock
        Exchange. Trading in our ordinary shares on these markets is made in different
        currencies (dollars on The Nasdaq Global 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.
  **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 and annual results of operations. At the
        beginning of 2008, we released financial guidance to the public with respect
        to
        the forthcoming year. We intend to continue to release to the public at the
        beginning of each year an annual financial guidance. Should our actual results
        of operations fall short of our guidance or analysts’ estimates, the price of
        our ordinary shares may decline.
  10


***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 high level
        of
        violence between Israel and the Palestinians. Hamas, an Islamist movement
        responsible for many attacks, including missile strikes, against Israelis,
        won
        the majority of the seats in the Parliament of the Palestinian Authority
        in
        January 2006 and took control of the entire Gaza Strip, by force, in June
        2007.
        These developments have further strained relations between Israel and the
        Palestinian Authority. Further, in the summer of 2006, Israel engaged in
        a war
        with Hezbollah, a Lebanese Islamist Shiite militia group, which involved
        thousands of missile strikes and disrupted most day-to-day civilian activity
        in
        northern Israel. Any armed conflicts, terrorist activities, or political
        instability in the region, 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. Furthermore, several countries restrict business with Israeli
        companies. In addition, nonexempt male adult citizens of Israel, including
        some
        of our officers and employees, are obligated to perform military reserve
        duty
        until the age of 40 or 45 depending on their function in the army, and are
        subject to being called for active duty under emergency circumstances. While
        we
        have operated effectively under these requirements since our incorporation, we
        cannot
        predict the full impact of such conditions on it in the future, particularly
        if
        emergency circumstances occur. If many of our employees are called for active
        duty, our operations in Israel and our business may be adversely
        affected.
  In
        2005,
        Israel experienced unionized general strikes in connection with economic
        reforms
        being passed into legislation. In addition, during July and August 2006,
        Haifa
        Port was closed as a result of the escalation of the military conflict in
        northern Israel. 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 or a disruption of any of the Israeli ports for an extended period
        of
        time, would affect our ability to deliver our products to our non-Israeli
        customers. We cannot guarantee that a prolonged general strike in Israel
        or a
        disruption of any of the Israeli ports as a result of a military conflict
        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.**
  Several
        of our expansion programs in Israel have been granted approved and privileged
        enterprise status. We are therefore eligible for tax benefits under the Israeli
        Law for Encouragement of Capital Investments, 1959. 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 and privileged
        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.
  11
  **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.**
  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:
  ·
              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 organized as
        a
        corporation in Israel in 1985 under the laws of the State of Israel. Our
        principal executive offices are located at 35 Efal Street, Kiryat Arye, Petach
        Tikva, Israel 49511, and our telephone number is 972-3-978-1222. Our agent
        in
        the United States is Aladdin Knowledge Systems Inc., 601 Campus Dr. Ste C-1,
        Arlington Heights, Illinois 60004, and its telephone number is 1-847-818-3800.
        Our Internet address is: http://www.Aladdin.com. Information on our web site
        is
        not incorporated by reference in this annual report.
  12
  ***Capital
        Expenditures***
  During
        the past three years, our capital expenditures amounted to approximately
        $10.2
        million. 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.
  **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. We have experienced
        significant growth since our founding in 1985. 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 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
        provide solutions primarily to the hardware-based software licensing
        authentication token, or SLAT, market, which is
        the
        largest segment of the software DRM market. We launched our new generation
        of
        HASP, HASP SRM, in March 2007. HASP SRM combines software-based software
        DRM
        solution together with hardware-based solution in a single platform. We
        anticipate that HASP SRM will increase our global presence in the software-based
        software DRM field. ****** 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.
  ***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.
  13
  ***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 2007 study by the Business Software Alliance and International Data
        Corporation ("IDC"), software developers lost $39.6 billion of potential
        revenue
        in 2006 due to software piracy, and in some countries approximately 90% of
        all
        software in use is pirated. Software pir acy
        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 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. Software DRM solutions
        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).
  14
  ***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, like a password, to strong or two-factor systems that rely
        on
        multiple factors such as something the user has, like a token, as well as
        something the user knows (like a password). Strong authentication systems
        include, among others, One Time Password ("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.
  ***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), Health Insurance Portability and Accountability Act
                  (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
                  with 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. A
                  key
                  directive that influences the authentication market, is FIPS 201
                  in the US
                  federal government sector. Based on this directive, federal institutes
                  will require secure access solutions that comply with FIPS 201
                  certification. We believe that this requirement will move into
                  the
                  enterprise sector in the future.
  ·
              **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.
  15
  ***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.
  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.
  16
  ·
              **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**.
                  Spam traffic has been continuously increasing in recent years.
                  It is
                  estimated that SPAM mail represents more than 80% of total email
                  traffic
                  globally. The industry consensus is that this trend will continue
                  and
                  intensify in the future.
  ·
              **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. Millions of people around the
                  world who
                  use the Internet receive phishing emails, and online shoppers lose
                  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, HIPAA and SOX,
                  each
                  require enhanced protection of sensitive personal and corporate
                  data,
                  thereby forcing organizations to take additional measures to protect
                  their
                  networks.
  ***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 implementdiffering
                  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 our customers to provide
                  time-based licensing and security; and
  17
  ·
              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 2007, like in preceding
                  years,
                  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 a combination of tokens, 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
                  token product offering is highly integrated within our customers’ IT
                  environment allowing enterprises to deploy any combination of tokens
                  according to their specific needs.****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 token draws its power from the USB port which eliminates
                  the
                  need for batteries, 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.
  18
  *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
        2008. Current initiatives include the following:
  ·
              expanding
                  our eToken line of products, including a Java card based token
                  and smart
                  card, an eToken SSO 5.0 for the single sign-on, or SSO, market
                  and a
                  new eToken OTP only based device (eToken Pass) for the enterprise
                  market;
  ·
              introducing
                  a new innovative and powerful architecture for Token management
                  system
                  (TMS) and eToken security applications;
  ·
              progressing
                  during 2008 with the certification process of the eToken devices
                  according
                  to the Common Criteria and FIPS 140-2 level 2&3 certifications to the
                  new Java card based devices;
  ·
              enhancing
                  our offerings to the service providers
                  market;
  ·
              enhancing
                  our enterprise offering;
  ·
              developing
                  new software authentication solutions for enterprise and consumer
                  authentication; and
  19
  ·
              developing
                  clientless tokens to enterprise and consumer authentication.
  *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 2007 were from repeat customers. In the software DRM field,
        repeat customers accounted for approximately 95% of our sales.  In
        addition, w e
        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 three 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 increase our channel sales to
        accelerate the growth of our enterprise security segment particularly by
        establishing OEM relationships with large technology vendors. In addition,
        we
        are exploring new business opportunities for the eToken product, including
        selling the eToken to on-line service providers for consumer authentication
        and
        marketing our new eToken SSO 5.0 to the SSO market.
 
 *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.
  20
  ·
              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.
  ·
              HASP
                  SRM launched in March 2007, is a new generation of HASP that combines
                  hardware-based and software-based technologies into a single platform,
                  giving customers the flexibility of mixing and matching protection
                  strategies across their product lines and target
                  markets.
  *Enterprise
        Security*
  Our
        enterprise security products address both safe access to networks, computers,
        applications and data (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 (OTP) functionality for authentication
                  in detached mode, eToken PRO, a two-factor authenticator that employs
                  a
                  readerless smart card and is primarily used for secure network
                  access and
                  digital signing, eToken NG-FLASH that offers the same functionality
                  as
                  eToken PRO, with the addition of flash memory for mobile data storage
                  ,
                  and eToken PASS, an OTP authentication device. All eToken devices
                  can
                  integrate with proximity technology for secure physical
                  access.
  ·
              **eToken**security
                  applications, including software enabling certificate based and
                  one-time-password based strong authentication, and single sign-on
                  applications enabling secure storage and management of user authentication
                  credentials on-board the token.
  ·
              **eToken**SDKs
                  (software development kits) that provide the APIs (application
                  programming
                  interfaces) and supporting documentation to enable 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
                  user 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. Our solutions are targeted at the enterprise and the service providers
        market.
  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.
  21
  ***Sales
        and Marketing***
  *Sales*
  We
        sell
        our software DRM products primarily to software developers and distributors
        while we sell our enterprise security solutions primarily through distributors,
        value-added resellers and system integrators. None of our customers accounted
        for more than 10% of our total revenues in 2005, 2006 or 2007.
  In
        2007,
        we recorded revenues of approximately $46.9 million from sales by distributors,
        representing 44% of our total revenues.
  For
        a
        breakdown of our revenues by geographic markets, see “Item 5. Operating and
        Financial Review and Prospects-Revenue trends and drivers.”
  We
        market
        and sell our software DRM solutions directly through our head office in Israel
        and through our international subsidiaries, including in the United States,
        the
        United Kingdom, Germany, France, the Netherlands, Spain, Italy, China, India
        and
        Japan. In addition, we have about 30 distributors covering additional countries
        not covered by our subsidiaries. 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
        April
        2007, the Consortium for Indian Information Technology Education, referred
        to as
        CIITE, selected our eToken authentication solution to secure its vast network
        of
        e-Learning resources throughout India. During a three-year period, our eToken
        will be provided to CIITE's students wishing to access the CIITE Educational
        Portal. eToken will secure access to online academic services, including
        online
        libraries, video-based learning, and IT-related texts. CIITE's initiative
        emphasizes the use of technology among the country's current and upcoming
        generations of young professionals.
 
 In
        addition to eToken, we have provided CIITE with eSafe content security solution
        and an authentication course - a comprehensive educational product,
        including academic-level DVD training course detailing authentication and
        security. This course will be used by students in CIITE-supported institutes
        and
        high-level educational organizations.
  *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 press relations management;
  ·
              industry
                  analyst relations programs;
  ·
              direct
                  mail and channel-related campaigns;
  22
  ·
              e-mail
                  sponsorships and campaigns;
  ·
              publication
                  of technical and educational articles in industry journals;
  ·
              participation
                  in,and presenting research papers at,industry trade shows;
  ·
              organization
                  of, and participation in, product and technology conferences and
                  seminars;
  ·
              competitive
                  analysis and dissemination of materials demonstrating Aladdin’s
                  superiority;
  ·
              sales
                  and technical events and roadshows for channel partners, customers,
                  and
                  prospects;
  ·
              advertising
                  in trade and industry focused magazines;
  ·
              Internet
                  promotion andadvertising
                  activities;
  ·
              production
                  and broadcast of webinars,
                  blogs, and other new media;
  ·
              development
                  and distribution of literature about our company; 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 was acquired by Vector
        Capital in March 2007). 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 the software business unit of 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 EMC Corporation (formerly 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. Our principal competitor in the USB-based strong authentication market
        is
        SafeNet, in addition to Gemplus Incorporated S.A. and Eutron SpA. According
        to a report of Lazard Capital Markets in November 2006, we accounted for
        34% of
        the global USB hardware authentication market in 2005, while SafeNet accounted
        for 25% of the market. The authentication
        market in which
        we operate is growing very fast during recent years. Accordingly, we face
        additional competition from new competitors and players in this field. In
        addition, large smart card vendors, such as Gemalto and Giesecke & Devrient
        GmbH (G&D), have begun also focusing
        on the enterprise and consumer authentication business.
  *Content
        security.* Our
        primary competitors in the content security market for gateway solutions
        are
        BlueCoat, Fortinet, Trend Micro Inc., Websense Inc. and Secure Computing
        Corporation.  Each of them holds a significant 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 75% of global revenues in this market,
        as well as a large number of smaller companies.
  23
  Vendors
        of firewalls might decide to extend their offerings to gateway security,
        and
        these could compete with our eSafe product. In
        the
        field of Internet service providers’ solutions, we currently face a slight
        competition, but it may intensify in the future.
  ***Intellectual
        Property***
  We
        have
        devoted over 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.
  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. We have 28 registered patents and 43 pending applications in the
        United
        States. We also had 12 registered patents and 57 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.
  24
  *Environmental
        Regulation*
  Our
        European activities require us to comply with European Union Directives with
        respect to product quality assurance standards and environmental standards,
        including 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). 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. Complying with this
        directive imposes some additional costs and administrative burden on us.
        European Directive 2002/96/EC on waste, electrical and electronic equipment,
        known 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. We may incur financial
        responsibility for the collection, recycling, treatment or disposal of products
        covered under the WEEE Directive. 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. We have entered
        into arrangements with subcontractors with respect to the assembly of our
        products, and to a limited extent, turnkey manufacturers. We believe that
        our
        current manufacturing facility, together with our arrangements with
        subcontractors and turnkey manufacturers and any future similar arrangements,
        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.
  ·
              **eSafe**-
                  We purchase several models of appliances hardware from a single
                  vendor, on which we install eSafe product and sell the bundled
                  solution to
                  customers.
  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.
  25
  We
        license the anti-spam and web filtering functions incorporated in our eSafe
        product pursuant to license agreements which are automatically renewed for
        successive one-year terms, unless a notice of termination is given by either
        of
        the parties prior to the renewal. We pay our licensors royalties consisting
        of a
        percentage of our revenues from eSafe. In the event that any of our licensors
        cancels the 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 (New York)Aladdin
                  Japan & Co. Inc.
              
              JapanAladdin
                  Europe Ltd. (formerly Aladdin Western Europe Ltd.)
              
              England
                  and WalesAladdin
                  Knowledge Systems India Pvt(1)
              
              IndiaAladdin
                  Europe BV (formerly Aladdin Western Europe BV )(2)
              
              The
                  NetherlandsAladdin
                  Europe S.A.R.L. (formerly Aladdin Western Europe S.A.R.L .)(2)
              
              FranceAladdin
                  Europe S.L.(2)
              
              SpainAladdin
                  Europe GmbH (formerly Aladdin Knowledge Systems Deutschland
                  GmbH)(2)(3)
              
              GermanyAladdin
                  Knowledge Systems Italy SRL(2)
              
              Italy
 
 
 (1)
              99%
                  of the outstanding share capital of this subsidiary is owned by
                  Aladdin
                  Knowledge Systems Ltd., and the remaining 1% shareholding is owned
                  by our
                  wholly-owned holding company, Hafalad BV, incorporated in the Netherlands.
 (2)
              Hafalad
                  BV, our wholly-owned holding company, wholly owns this subsidiary.
                  This
                  subsidiary is involved in distribution, support and management
                  of our
                  products.
 (3)
              This
                  subsidiary provides us with research and development
                  services.
  **** We
        also
        have a representative office in China.
  **D.****Property,
        Plants and Equipment**
  Our
        corporate headquarters and principal research and development facilities
        are
        located at Kiryat Arye industrial area in Petach Tikva, Israel. These facilities
        consist of 51,171 square feet which are leased for 5 years ending in August
        2011, with an option to extend for an additional 5 years. Our manufacturing
        facility is located in a 11,755 square foot facility in Kiryat Gat, Israel.
        We
        lease this facility pursuant to a lease agreement that expires in June 2008,
        with an option to extend for an additional two years. We also lease a 13,659
        square foot facility in Tirat Hacarmel, Israel used for our content security
        research and development activities, for a term expiring in December 2009,
        with
        an option to extend for two additional periods of 6 years in the
        aggregate.
  26
  Our
        subsidiaries also lease facilities in France, Germany, Japan, the Netherlands,
        the United Kingdom, Spain, Italy, China, India and the United States. These
        facilities are primarily used for sales and marketing functions. We also
        conduct
        research and development activities at our facilities near Munich,
        Germany.
  Our
        aggregate annual lease expenses in 2007 for our facilities were $2.5 million.
        We
        believe that our current facilities, including our 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
        requir e
        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.**
  ***Overview***
  We
        are a
        global provider of security solutions that reduce software theft, authenticate
        network users and protect against unwanted Internet and email-borne content,
        including spam and viruses. Our products are divided into two segments: software
        digital rights management (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 the 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 last decade, 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 penetrated
        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, we returned to profitability. At the beginning of 2004, we constituted
        our enterprise security segment as a separate reportable segment. In 2007,
        we
        generated 62% of our revenues from our software DRM segment and the rest
        from
        our enterprise security segment. All of our profits in 2007 were derived
        from
        our software DRM segment, as presented in Note 15 to our consolidated financial
        statements.
  ***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 growth of our enterprise security segment although we
        currently derive all of our profit from the software DRM segment, as presented
        in Note 15 to our consolidated financial statements. 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,****2005**
                
                **2006**
                
                **2007**Software
                    DRM
                
                
                69
                %
                
                68
                %
                
                62
                %Enterprise
                    security
                
                
                31
                %
                
                32
                %
                
                38
                %
  27
  ***Revenues***
  We
        generate revenues from two main sources: sales of hardware products and software
        licenses. To date, we have derived the most of our revenues from sales of
        hardware products, although our software licenses have increased as a percentage
        of sales over the past five years.
  In
        2005,
        2006 and 2007, 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. We also refer you to "Item 11. Quantitative and
        Qualitative Disclosures About Market Risk” below 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, 2005, 2006 and 2007.
  ***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,
        no further obligation exists and collectibility is probable.
  **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. License fees are recognized 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.
        When the agreement includes multiple elements, we determine the fair value
        of
        the maintenance and support component, which includes the right to periodic
        updates on when and if available basis, 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 include 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.
  Deferred
        revenues include unearned amounts received from maintenance and support
        contracts.
  Our
        deferred revenues as of December 31, 2006 and 2007 were $6.2 million and
        $8.2 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
        customer accounted for more than 10% of our revenues.
  28
  **Geographic
        breakdown.** The
        following table sets forth the geographic breakdown of our revenues for the
        periods indicated:
  **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**United
                    States
                
                
                33
                %
                
                26
                %
                
                23
                %Europe
                    (excluding Germany)
                
                
                26
                
                
                30
                
                
                32Germany
                
                
                21
                
                
                22
                
                
                23Japan
                
                
                11
                
                
                10
                
                
                7Israel
                
                
                4
                
                
                5
                
                
                5APAC
                
                
                2
                
                
                5
                
                
                8Others
                
                
                3
                
                
                2
                
                
                2**Total**
                
                
                **100**
                **%**
                
                **100**
                **%**
                
                **100**
                **%**
 
 **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 2007 was from repeat customers.
  **Cost
        of revenues and gross profit**
  **Software
        DRM.** Cost
        of
        revenues for our software DRM products consist 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 consist primarily of the cost of components,
        manufacturing costs (including costs of subcontractors and to a limited extent,
        turnkey manufacturers), 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 consist primarily
        of
        costs associated with the provision of technical support, appliances 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. In 2007, cost of revenues included a $2.5 million
        fully expensed cost of developing and producing video based training materials
        in a tender in which we participated.
  ***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.  Due to the short term
        between development and general availability of our products all research
        and
        development costs are expensed as incurred.
  29
  **Selling
        and marketing.** Selling
        and marketing expenses consist primarily of salaries and related expenses,
        commissions, 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, 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, interest and impairment on our investments in marketable securities,
        and foreign currency gains or losses.
  **Taxes
        on income.** Although
        Israeli companies were generally subject to income tax at the corporate rate
        of
        29% in 2007, 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 (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, 2007, our allowance for doubtful accounts was
        $401,000 and our trade receivables were $16.9 million.
  *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 provision is made.
  30
  *Share
        based payments*
  On
        January 1, 2006, we adopted Statement of Financial Accounting Standards
        No. 123 (revised 2004), "Share-Based Payment", referred to as SFAS 123(R),
        which requires the measurement and recognition of compensation expense based
        on
        estimated fair values for all share-based payment awards made to employees
        and
        directors. SFAS 123(R) supersedes Accounting Principles Board Opinion
        No. 25, "Accounting for Stock Issued to Employees", or APB 25, under which
        we previously accounted for our share based awards granted to employees and
        directors. In March 2005, the Securities and Exchange Commission issued Staff
        Accounting Bulletin No. 107, or SAB 107, relating to SFAS 123(R). We have
        applied the provisions of SAB 107 in our adoption of SFAS 123(R).
 
 SFAS
        123(R) requires companies to estimate the fair value of equity-based payment
        awards on the date of grant using an option-pricing model. The value of the
        portion of the award that is ultimately expected to vest is recognized as
        an
        expense over the requisite service periods in our consolidated income statement.
        Prior to the adoption of SFAS 123(R), we accounted for equity-based awards
        to
        employees and directors using the intrinsic value method in accordance with
        APB
        25 as allowed under Statement of Financial Accounting Standards No. 123,
        "Accounting for Stock-Based Compensation", or SFAS 123. Our determination
        of
        fair value of share-based payment awards on the date of grant using an
        option-pricing model is affected by our stock price as well as assumptions
        regarding a number of highly complex and subjective variables. These variables
        include, but are not limited to our expected stock price volatility over
        the
        terms of the awards, and actual and projected employee stock option exercise
        behaviors. Although the fair value of employee stock options is determined
        in
        accordance with SFAS 123(R) and SAB 107 using an option-pricing model, that
        value may not be indicative of the fair value observed in a willing
        buyer/willing seller market transaction.
 
 We
        adopted SFAS 123(R) using the modified prospective transition method, which
        requires the application of the accounting standard starting from
        January 1, 2006, the first day of our fiscal year 2006. Under that
        transition method, compensation cost recognized in 2006, includes: (a)
        compensation cost for all share-based payments granted prior to, but not
        yet
        vested as of January 1, 2006, based on the grant date fair value estimated
        in
        accordance with the original provisions of SFAS 123; and (b) compensation
        cost
        for all share-based payments granted subsequent to January 1, 2006, based
        on the
        grant-date fair value estimated in accordance with the provisions of SFAS
        123(R). Results for prior periods have not been restated.
  We
        used
        the Black-Scholes-Merton option-pricing model in 2006 through June 30, 2007
        and
        the Monte-Carlo Simulation model thereafter, to estimate the fair value of
        options granted. The Monte-Carlo model considers characteristics of fair
        value
        option pricing that are not available under the Black-Scholes-Merton model.
        Similar to the Black-Scholes model, the Monte-Carlo model takes into account
        variables such as volatility, dividend yield rate, and risk free interest
        rate.
        However, in addition, the Monte-Carlo model considers the contractual term
        of
        the option, the probability that the option will be exercised prior to the
        end
        of its contractual life, and the probability of termination or retirement
        of the
        option holder in computing the value of the option. For these reasons, we
        believe that the Monte-Carlo model provides a fair value that is more
        representative of actual experience and future expected experience than that
        calculated using the Black-Scholes model.
  As
        a
        result of adopting SFAS 123(R) on January 1, 2006, our income before taxes
        in
        2006, was $2.3 million lower than if we had continued to account for stock-based
        compensation under APB 25. Basic and diluted net earnings per share for 2006,
        were both $0.15 lower than if we had continued to account for share-based
        compensation under APB 25.
  We
        recognize compensation expenses for the value of our awards, which have graded
        vesting, based on the accelerated attribution method over the vesting period,
        net of estimated forfeitures. Estimated forfeitures are based on actual
        historical pre-vesting forfeitures. Differences between estimated and actual
        forfeitures are reflected when probable.
  *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 $3.3 million as of December 31,
        2007. Deferred tax assets, related valuation allowances and deferred tax
        liabilities are determined separately for each tax jurisdiction. We believe
        that
        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.
  31
  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.
  In
        June
        2006, the Financial Accounting Standards Board (FASB) issued Interpretation
        No.
        48 “Accounting for Uncertainty in Income Taxes—An interpretation of FASB
        Statement No. 109”, or FIN 48. FIN 48 clarifies the accounting for uncertainties
        in income taxes recognized in an enterprise’s financial statements and
        prescribes a recognition threshold and measurement attributes of income tax
        positions taken or expected to betaken on a tax return. Under FIN 48, the
        impact
        of an uncertain tax position taken or expected to be taken on an income tax
        return must be recognized in the financial statements at the largest amount
        that
        is more-likely-than-not to be sustained upon audit by the relevant taxing
        authority. An uncertain income tax position will not be recognized in the
        financial statements unless it is more likely than not of being sustained.
        We
        adopted the provisions of FIN 48 as of January 1, 2007. The impact of adopting
        of FIN 48 was insignificant to our consolidated financial statements in the
        total amount of $182,000.
 Tax
          returns are subject to audit by various taxing authorities. Although we
          believe
          that adequate accruals have been made for uncertain tax positions, additional
          gains or losses could occur in future years from resolution of outstanding
          matters. We continue to assess our uncertain tax benefits 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”, or SFAS 142, goodwill acquired in a business combination is
        deemed to have indefinite life and will not be amortized. SFAS 142 requires
        goodwill to be tested for impairment at least annually and between annual
        tests in certain circumstances, and written down when impaired. Goodwill
        is
        tested for impairment by comparing the fair value of each reporting units
        with
        its carrying value. Our reporting units for purposes of the impairment test
        are
        our two operating segments, the software security DRM, and enterprise security.
        Fair value is determined for 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. Significant estimates used
        in
        the methodologies included estimates of future cash flows and estimates of
        discount rates. As of December 31, 2007, we had total goodwill of $7.7
        million on our balance sheet. We perform the annual impairment tests during
        the
        fourth quarter every year and no impairment losses were identified. In assessing
        the recoverability of our goodwill, 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.
  *Intangible
        Assets*
  Intangible
        assets acquired are amortized over their useful life 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 SFAS
        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 estimated useful life, as described
        in
        Note 2 to our consolidated financial statements.
  *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 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. In 2005, 2006 and 2007, we have not
        recorded impairment charges for long-lived assets.
  32
  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.
  *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 investees. 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.
  During
        2006 and 2007, we invested in Athena Smartcard Solution Ltd., referred to
        as
        Athena, a Japanese company and an expert in developing smart card systems.
        The
        investment in this company is being accounted for using the equity method.
  In
        January 2008, we increased our shareholdings in Athena to 38.8% by investing
        an
        additional $3 million in Athena. As part of this transaction, we were granted
        an
        option, exercisable in 2011, to acquire the entire share capital of Athena
        from
        its current shareholders, based on Athena's performance in 2010. Furthermore,
        in
        order to prevent a takeover of Athena before 2011, when the option becomes
        exercisable, the agreement provides that in the event that any other party
        offers to purchase the entire share capital of Athena at any time before
        the end
        of 2010, we shall have a right of first refusal to purchase all the shares
        from
        the other shareholders, at a 20% discount from the offered price. This right
        of
        first refusal will also apply to any offers by third parties to acquire any
        substantial part of the business, assets or intellectual property of Athena,
        including by way of a merger. We were also granted the right to appoint one
        director (out of five) to Athena's board.
  Due
          to
          the above mentioned investment and related rights, we will consolidate
          Athena
          from the closing date of the additional investment based on the guidance
          of
          Financial Accounting Standards Board (“FASB”) Interpretation No. 46R (“FIN
          46R”), “Consolidation of Variable Interest Entities, an Interpretation of
          Accounting Research Bulletin No.51”, as revised.
 *Litigation*
  Management
        sets aside liabilities related to litigation brought against us when it is
        probable that a loss has been incurred and 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, our
        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.
  ***Impact
        of recently issued accounting standards***
  In
        September 2006, the FASB issued Statement of Financial Accounting Standards
        No.
        157, “Fair Value Measurements”, or SFAS 157, which defines fair value,
        establishes a framework for measuring fair value, and expands disclosures
        about
        fair value measurements. SFAS 157 applies to other accounting pronouncements
        that require or permit fair value measurements and, accordingly, does not
        require any new fair value measurements. SFAS 157 is effective for fiscal
        years
        beginning after November 15, 2007 for financial assets and liabilities, as
        well
        as for any other assets and liabilities that are carried at fair value on
        a
        recurring basis, and should be applied prospectively. The adoption of the
        provisions of SFAS 157 related to financial assets and liabilities and other
        assets and liabilities that are carried at fair value on a recurring basis,
        is
        not anticipated to materially impact our consolidated financial position
        and
        results of operations. Subsequently, the FASB provided for a one-year deferral
        of the provisions of SFAS 157 for non-financial assets and liabilities that
        are
        recognized or disclosed at fair value in the consolidated financial statements
        on a non-recurring basis. We are currently evaluating the impact of adopting
        the
        provisions of SFAS 157 for non-financial assets and liabilities that are
        recognized or disclosed on a non-recurring basis.
  33
  In
        February 2007, the FASB issued Statement of Financial Accounting Standards
        No.
        159, “The Fair Value Option for Financial Assets and Financial Liabilities”, or
        SFAS 159. Under this Standard, we may elect to report financial instruments
        and
        certain other items at fair value on a contract-by-contract basis with changes
        in value reported in earnings. This election is irrevocable. SFAS 159 provides
        an opportunity to mitigate volatility in reported earnings that is caused
        by
        measuring hedged assets and liabilities that were previously required to
        use a
        different accounting method than the related hedging contracts when the complex
        provisions of SFAS 133 hedge accounting are not met. SFAS 159 is effective
        for
        years beginning after November 15, 2007. We do not expect the adoption of
        SFAS
        159 will have a material impact on our consolidated financial
        statements.
  In
        December 2007, the FASB issued Statement of Financial Accounting Standards
        No.
        141 (Revised 2007)“Business Combinations”, or SFAS 141R. SFAS 141R will change
        the accounting for business combinations. Under SFAS 141R, an acquiring entity
        will be required to recognize all the assets acquired and liabilities assumed
        in
        a transaction at the acquisition-date fair value with limited exceptions.
        SFAS
        141R will change the accounting treatment and disclosure for certain specific
        items in a business combination. SFAS 141R applies prospectively to business
        combinations for which the acquisition date is on or after the beginning
        of the
        first annual reporting period beginning on or after December 15, 2008. SFAS
        141R
        will have an impact on accounting for future business combinations once adopted
        and not on prior acquisitions.
  In
        December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
        Consolidated Financial Statements,” referred to as SFAS 160. SFAS 160
        establishes accounting and reporting standards for ownership interests in
        subsidiaries held by parties other than the parent, the amount of consolidated
        net income attributable to the parent and to the non-controlling interest,
        changes in a parent’s ownership interest and the valuation of retained
        non-controlling equity investments when a subsidiary is deconsolidated. SFAS
        160
        also establishes reporting requirements that provide sufficient disclosures
        that
        clearly identify and distinguish between the interests of the parent and
        the
        interests of the non-controlling owners. This standard is effective for fiscal
        years beginning after December 15, 2008 and should be applied prospectively.
        However, the presentation and disclosure requirements of the statement shall
        be
        applied retrospectively for all periods presented. The adoption of the
        provisions of SFAS 160 is not anticipated to materially impact our consolidated
        financial position and results of operations.
  34
  **A.**  **Operating
        Results**
  The
        following table sets forth certain statement of operations data as a percentage
        of revenues for the periods indicated:
  **Year
                    ended December 31,********2005**
                
                ******2006**
                
                ******2007****Revenues:**Software
                    security
                
                
                69.2
                %
                
                68.0
                %
                
                62.0
                %Enterprise
                    security
                
                
                30.8
                
                
                32.0
                
                
                36.0Revenues
                    related to educational products
                
                
                -
                
                
                -
                
                
                2.0Total
                    revenues
                
                
                100.0
                
                
                100.0
                
                
                100.0**Cost
                    of revenues:**Software
                    security
                
                
                12.1
                
                
                10.5
                
                
                11.1Enterprise
                    security
                
                
                8.7
                
                
                12.0
                
                
                12.4Cost
                    related to educational products
                
                
                -
                
                
                -
                
                
                2.4Total
                    cost of revenues
                
                
                20.8
                
                
                22.5
                
                
                25.8Gross
                    profit
                
                
                79.2
                
                
                77.5
                
                
                74.2**Operating
                    expenses:**Research
                    and development
                
                
                14.8
                
                
                16.1
                
                
                17.4Selling
                    and marketing
                
                
                33.0
                
                
                32.2
                
                
                31.4General
                    and administrative
                
                
                13.7
                
                
                14.4
                
                
                12.3One-time
                    lawsuit charge
                
                
                2.4
                
                
                -
                
                
                -Total
                    operating expenses
                
                
                63.9
                
                
                62.7
                
                
                61.1Operating
                    income
                
                
                15.3
                
                
                14.8
                
                
                13.1Financial
                    income, net
                
                
                1.3
                
                
                3.7
                
                
                4.1Other
                    income, net
                
                
                -
                
                
                0.3
                
                
                -Income
                    before taxes on income
                
                
                16.6
                
                
                18.8
                
                
                17.2Taxes
                    on income
                
                
                1.5
                
                
                3.0
                
                
                2.6Income
                    before equity in loss of an affiliate
                
                
                15.1
                
                
                15.8
                
                
                14.6Equity
                    in loss of an affiliate
                
                
                -
                
                
                -
                
                
                (0.5
                )Net
                    income
                
                
                15.1
                %
                
                15.8
                %
                
                14.1
                %
 
 ***Year
        ended December 31, 2007 compared to year ended December 31, 2006***
  *Revenues*
  Total
        revenues increased by 19% to $105.9 million in 2007 from $89.0 million in
        2006.
  **Software
        DRM.** Revenues
        from software DRM increased by 9.2% to $66.1 million in 2007 from $60.6 million
        in 2006. This increase was attributable to increased HASP sales in international
        markets, mainly in Europe and APAC.
  **Enterprise
        security.** Revenues
        from enterprise security increased by 40% to $39.8 million in 2007 from $28.5
        million in 2006. This increase was attributable to a 54% increase in eToken
        sales mainly in Europe and APAC and a 20.4% increase in eSafe sales, mainly
        in
        the Israeli local market and in Europe.
  35
  *Cost
        of revenues*
  Total
        cost of revenues increased by 36.6% to $27.3 million in 2007 from $20.0 million
        in 2006.
  **Software
        DRM.** Cost
        of
        revenues for software DRM increased by 26.4% to $11.7 million in 2007 from
        $9.3
        million in 2006. This increase was primarily attributable to an increase
        in
        overhead costs needed to support our increased revenues. Gross margin from
        software DRM products decreased to 82.2% in 2007 compared to 84.7% in
        2006.
  **Enterprise
        security.** Cost
        of
        revenues for enterprise security increased by 45.4% to $15.6 million in 2007
        from $10.7 million in 2006. An increase of $2.5 million is attributable to
        the
        cost of developing and producing video based training ("VBT") materials in
        a
        tender in which we participated. The increase is also attributable to an
        increase in sales of our enterprise security products. Gross margin from
        enterprise security, excluding the VBT cost, increased to 65.4% in 2007
        compared to 62.4% in 2006. In 2006, we recorded a decrease in gross margin
        attributable to several deals we had in the Asia-Pacific region that were
        conducted at a low gross margin in order to penetrate this market. In 2007,
        the
        extent of this type of deals was significantly lower.
  Gross
        profit increased by 13.8% to $78.6 million in 2007 from $69.0 million in
        2006.
        Excluding the $2.5 million VBT cost, gross profit increased by 14.5% in 2007
        compared to 2006. Our gross margin, excluding the VBT cost, decreased to
        76.1%
        in 2007 from 77.5% in 2006, reflecting the mix between geographies and segments.
  *Research
        and development*
  Research
        and development expenses increased by 28.2% to $18.4 million in 2007 compared
        to
        $14.3 million in 2006, representing 17.4% of revenues in 2007 compared to
        16.1%
        in 2006. This increase was primarily attributable to a significant increase
        in
        the eToken research and development activity.
  *Selling
        and marketing*
  Selling
        and marketing expenses increased by 15.7% to $33.2 million in 2007 from $28.7
        million in 2006, in order to support our increased revenues. As a percentage
        of
        revenues, selling and marketing expenses decreased to 31.4% in 2007 compared
        to
        32.2% in 2006.
  *General
        and administrative*
  General
        and administrative expenses increased by 2.2% to $13.1 million in 2007 from
        $12.8 million in 2006. As a percentage of revenues, general and administrative
        expenses decreased to 12.3% in 2007 from 14.4% in 2006.
  *Financial
        income, net*
  Financial
        income, net, in 2007 was $4.3 million compared to financial income, net,
        of $3.2
        million in 2006. The increase was primarily attributable to interest income
        earned on the proceeds from our secondary offering consummated in 2005.
  *Taxes
        on income*
  Taxes
        on
        income were $2.8 million or 15.2% of income before taxes in 2007 compared
        to
        $2.7 million or 16.1% of income before taxes in 2006. The lower tax rate
        was
        primarily attributable to an increase in income before taxes from jurisdictions
        with lower tax rates.
  *Equity
        in loss of an affiliate.*
  Equity
        in loss of an affiliate increased from zero in
        2006 to $0.5 million in 2007 due to a loss of our affiliate, Athena Smartcard
        Solution, Ltd.
  36
  ***Year
        ended December 31, 2006 compared to year ended December 31, 2005***
  *Revenues*
  Total
        revenues increased by 8.9% to $89.0 million in 2006 from $81.8 million in
        2005.
  **Software
        DRM.** Revenues
        from software DRM increased by 7.0% to $60.6 million in 2006 from $56.6 million
        in 2005. This increase was attributable to increased HASP sales in our
        international markets, mainly in Europe and APAC.
  **Enterprise
        security.** Revenues
        from enterprise security increased by 13.0% to $28.5 million in 2006 from
        $25.2
        million in 2005. This increase was attributable to a 16.3% increase in eToken
        sales mainly in Europe, APAC and the Middle East and a 9.0% increase in eSafe
        sales, mainly in Europe, the Middle East and South America.
  *Cost
        of revenues*
  Total
        cost of revenues increased by 17.9% to $20.0 million in 2006 from $17.0 million
        in 2005.
  **Software
        DRM.** Cost
        of
        revenues for software DRM decreased by 5.9% to $9.3 million in 2006 from
        $9.9
        million in 2005. This decrease was primarily attributable to a decrease in
        subcontracting and overhead costs, due to our increased manufacturing efficiency
        resulting from our accumulated experience with our products. Gross margin
        from
        software DRM products increased to 84.7% in 2006 compared to 82.5% in
        2005.
  **Enterprise
        security.** Cost
        of
        revenues for enterprise security increased by 51.0% to $10.7 million in 2006
        from $7.1 million in 2005. This increase was attributable to the increase
        in
        sales of our enterprise security products. Gross margin from enterprise security
        decreased to 62.4% in 2006 compared to 71.8% in 2005. This decrease was mainly
        attributable to several deals we had in the Asia-Pacific region that were
        conducted at a low gross margin in order to penetrate this market. In addition,
        in 2005, we received a certain payment for licensing fees from one of our
        customers with respect of which we had no cost of revenues. We have not received
        any similar payment in 2006.
  Gross
        profit increased by 6.5% to $69.0 million in 2006 from $64.8 million in 2005.
        Our gross margin decreased to 77.5% in 2006 from 79.2% in 2005.
  *Research
        and development*
  Research
        and development expenses increased by 18.2% to $14.3 million in 2006 compared
        to
        $12.1 million in 2005, representing 16.1% of revenues in 2006 compared to
        14.8%
        in 2005. This increase was primarily attributable to a significant increase
        in
        the eToken research and development activity and to an increase of $666,000
        of
        stock based compensation expenses as a result of adopting SFAS
        123(R).
  *Selling
        and marketing*
  Selling
        and
        marketing expenses increased by 6.5% to $28.7 million in 2006 from $27.0
        million
        in 2005. This increase was mainly attributable to the increase of $732,000
        of
        stock based compensation expenses as a result of adopting SFAS 123(R). As
        a
        percentage of revenues, selling and marketing expenses were stable at 32.2%
        in
        2006 compared to 33.0% in 2005.
  37
  *General
        and administrative*
  General
        and administrative expenses increased by 14.4% to $12.8 million in 2006 from
        $11.2 million in 2005. This increase was primarily attributable to an increase
        in compensation expenses mainly $776,000 of stock based compensation expenses
        as
        a result of adopting SFAS 123(R). As a percentage of revenues, general and
        administrative expenses increased to 14.4% in 2006 from 13.7%
        in 2005.
  Operating
        expenses in 2005 included a $2.0 million one-time charge to settle a patent
        lawsuit representing 2.4% of revenues in 2005.
  *Financial
        income, net*
  Financial
        income, net, in 2006 was $3.2 million compared to financial income, net,
        of $1.0
        million in 2005. This increase was primarily attributable to interest income
        earned on the proceeds from our secondary offering consummated in 2005, net
        of
        losses resulting from currency fluctuations.
  *Taxes
        on income*
  Taxes
        on
        income were $2.7 million in 2006 compared to $1.2 million in 2005. In 2006,
        taxes on income in the amount of $2.8 million were partially offset by an
        increase in the deferred tax asset of $124,000 related to certain foreign
        net
        operating losses carried forward and other timing differences.
  **B.****Liquidity
        and Capital Resources**
  Our
        primary sources of liquidity are our cash, cash equivalents and marketable
        securities and our cash flow from operations. In 2005, we also had proceeds
        from
        our secondary offering completed on March 30, 2005. This underwritten public
        offering of 2,000,000 ordinary shares resulted in net proceeds to us of $38.8
        million after deducting the underwriting discount and offering expenses.
        As of
        December 31, 2007, we had cash, cash equivalents and marketable securities
        aggregating $90.3 million.
  On
        April
        1, 2007, our board of directors authorized the use of a portion of our available
        cash for the repurchase of Aladdin’s ordinary shares. According to the terms of
        the buy-back program approved by the board, we were authorized to repurchase
        Aladdin’s ordinary shares utilizing up to $10 million or to repurchase such
        number of ordinary shares not to exceed 500,000 shares. On June 11, 2007,
        our
        board of directors increased the extent of the buy-back program by an additional
        $10 million and on October, 25, 2007, our board of directors approved an
        additional increase of $10 million. The combined total authorization now
        stands
        at $30 million. As of December 31, 2007, we repurchased 928,697 shares utilizing
        approximately $20 million.
 
 Under
        the
        buy-back program, we are authorized to repurchase Aladdin’s shares, from time to
        time, in the open market, based on market conditions, share price and other
        factors. Purchases are made in compliance with the applicable provisions
        of
        Section 302 of the Israeli Companies Law, 1999, the applicable provisions
        of
        Rule 10b-18 of the Securities Exchange Act of 1934, as amended, referred
        to as
        the Exchange Act, and Regulation M promulgated under the Exchange Act. In
        accordance with the Israeli law, shares purchased by us under the buy-back
        program do not confer upon us any rights.
  Our
        operating activities provided cash in the amount of $22.1 million in 2007
        and
        $18.9 million in 2006. The major contributing factors in 2007 were higher
        net
        income excluding stock based compensation expenses and increase in trade
        payables, offset by an increase in accounts receivable, mainly attributed
        to the
        increase in revenues. Our operating activities provided cash in the amount
        of
        $18.9 million in 2006 compared to $14.6 million in 2005. In 2006, our cash
        generated from operating activities was impacted by higher net income excluding
        stock based compensation expenses, offset by an increase in accounts receivable,
        mainly attributed to the increase in revenues.
  38
  Our
        investing activities provided cash in the amount of $34.8 million in 2007,
        mainly consisting of proceeds from available-for-sale marketable securities
        less
        purchases in the amount of $38.6 million, offset by the purchase of property
        and
        equipment in the amount of $3.3 million and investment in other companies,
        in
        the amount of $0.5 million. Our investing activities used cash in the amount
        of
        $8.5 million in 2006, mainly consisting of investments in available-for-sale
        marketable securities less proceeds in the amount of $2.1 million, investment
        in
        other assets in the amount of $2.5 million and the purchase of property and
        equipment in the amount of $4.6 million, offset by proceeds from return on
        investments of other companies, net of investment in other companies, in
        the
        amount of $0.6 million. 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
        financing activities used cash in the amount of $19.3 million in 2007,
        consisting of $20 million used for the purchase of our shares under our share
        buy-back program which were offset by $0.7 million resulting from the exercise
        of stock options by employees. In 2006 and 2005, our financing activities
        provided cash in the amount of $0.8 million and $39.3 million, respectively,
        resulting mainly from the exercise of stock options by employees in 2006
        and
        receipt of proceeds from issuance of shares in 2005 and proceeds from the
        exercise of stock options by employees.
  We
        had
        working capital of $104.0 million as of December 31, 2007, $100.6 million
        as of December 31, 2006 and $85.0 million as of December 31, 2005.
 
 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 twelve
        months.
  ***Investments***
  In
        April
        2004, we 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, we invested an aggregate amount of $1.1 million
        in
        IDesia Ltd. In addition, we incurred expenses in the amount of $50,000 in
        connection with this investment.  This investment consisted of a $550,000
        convertible loan, which was 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, we invested the
        remaining $500,000 by purchasing additional series A preferred shares of
        IDesia
        Ltd.
  During
        the first quarter of 2007, IDesia completed an additional investment round
        in
        which we did not participate, and therefore as of December 31, 2007, we owned
        16.58% of the share capital of IDesia.
  As
        of
        December 31, 2007, we invested an aggregate amount of $8.1 million in two
        investment funds managed by Tamir Fishman Ventures Management II Ltd.  We
        have no control over the operating and financial policies of these funds.
        In
        2002, we recorded an impairment charge of $1.0 million related to these
        investments.
  In
        2005
        and 2006, as a result of exit transactions of portfolio companies of Tamir
        Fishman, we received cash distributions of $910,000 and $1.7 million,
        respectively. The proceeds received from these cash distributions were recorded
        as a return of investment. In February 2008, we sold approximately 52% of
        our
        investment in the investment funds managed by Tamir Fishman. The consideration
        was $2.9 million and the net gain was $614,000. We expect to sell the remainder
        of this investment during 2008.
 
 In
        November 2006, we entered into an agreement with K.K. Athena Smartcard
        Solutions Ltd., a Japanese company, referred to as Athena, whereby we were
        granted an option allowing us to invest up to $745,000 in Athena at any time
        until June 30, 2007, in consideration for the issuance of shares of Athena.
        The
        option was exercised in three installments of $248,000 each, in November
        2006,
        January 2007 and April 2007.
  39
  In
        January 2008, we increased our shareholdings in Athena to 38.8% by investing
        an
        additional $3 million in Athena. As part of this transaction, we were granted
        an
        option, exercisable in 2011, to acquire the entire share capital of Athena
        from
        its current shareholders, based on Athena's performance in the 2010.
        Furthermore, in order to prevent a takeover of Athena before 2011, when the
        option becomes exercisable, the agreement provides that in the event that
        any
        other party offers to purchase the entire share capital of Athena at any
        time
        before the end of 2010, we shall have a right of first refusal to purchase
        all
        the shares from the other shareholders, at a 20% discount from the offered
        price. This right of first refusal will also apply to any offers by third
        parties to acquire any substantial part of the business, assets or intellectual
        property of Athena, including by way of a merger. We were also granted the
        right
        to appoint one director (out of five) to Athena's board.
  Due
          to
          the above mentioned investment and related rights, we will consolidate
          Athena
          from the closing date of the additional investment based on the guidance
          of
          Financial Accounting Standards Board ("FASB") Interpretation No. 46R ("FIN
          46R"), “Consolidation of Variable Interest Entities, an Interpretation of
          Accounting Research Bulletin No.51”, as revised.
  ***Corporate
        Tax***
  Israeli
        companies are generally subject to income tax at the declining corporate
        rate of
        29% in 2007, 27% in 2008, 26% in 2009 and 25% in 2010 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% (depending on the specific program)
        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 cancelled and we
        could
        be required to refund any tax benefits that we have already received, plus
        interest and penalties accrued 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 taxable income of our
        subsidiaries), our effective tax rate is a weighted average rate 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.
  As
        of
        December 31, 2007, the net operating loss carry-forwards of our subsidiaries
        for
        tax purposes amounted to $27.7 million, the majority of which related to
        our
        United States 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.
  **C.**  **Research
        and Development, Patents and Licenses**
  In
        2007,
        we spent $18.4 million on research and development activities, in 2006 we
        spent
        $14.3 million and in 2005 we spent $12.1 million. The increase in the amount
        spent on research and development activities in 2007 compared to 2006 and
        the
        increase in the amount spent in 2006 compared to 2005 were primarily
        attributable to a significant increase in the eToken research and development
        activity. The increase in the amount spent on research and development
        activities in 2006 compared to 2005 is also attributable to an increase of
        $666,000 of stock based compensation expenses as a result of adopting SFAS
        123(R).
  40
  For
        a
        description of our research and development activities, see “Item
        4. Information on the Company—Business Overview—Our Strategy—Extend our
        technology and introduce new products.”
  For
        information concerning our intellectual property rights, see “Item
        4. Information on the Company—Business Overview—Our Strategy—Intellectual
        Property.”
  **D.**  **Trend
        Information**
 
 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.
        If
        SaaS becomes a significant trend in the software industry it may adversely
        affect our results of operations.
  In
        addition, a number of participants in the computer industry are involved
        in an
        initiative to implement “trusted computing” functions which may replicate some
        of the features of our software DRM products. In particular, Microsoft
        Corporation is involved in the development of its “Next-Generation Secure
        Computing Base” architecture which, among other things, is intended to contain
        software DRM functionality. Furthermore, 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.
  Moreover,
        software developers are continuously adding security features to new versions
        of
        their software that are designed to limit intrusions by unauthorized users
        or
        viruses and spyware via the Internet. Microsoft has announced an anti-virus
        service geared towards consumers as well as a new strategy for anti-virus
        protection for businesses. In addition, the new version of Windows (Vista)
        has
        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 and content security
        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.
  **E.**  **Off-Balance
        Sheet Arrangements**
 
 We
        do not
        have any off-balance sheet arrangements.
  41
  **F.**  **Tabular
        Disclosure of Contractual Obligations** ****
  The
        following table summarizes our contractual obligations and commercial
        commitments as of December 31, 2007:
  **Contractual
                    obligations**
                
                **Total**
                
                **Less****than
                    1****year**
                
                **1-3****years**
                
                **3-5****years**
                
                **More
                    than 5****Years**Operating
                    lease obligations (1)
                
                $
                9,137
                
                $
                3,667
                
                $
                3,010
                
                $
                2,460
                
                
                —Purchase
                    obligations (2)
                
                
                5,353
                
                
                5,353
                
                
                —
                
                
                —
                
                
                —Other
                    long-term obligations (3)
                
                
                208
                
                
                208
                
                
                —
                
                
                —
                
                
                —Total
                    contractual obligations
                
                $
                14,698
                
                $
                9,228
                
                $
                3,010
                
                $
                2,460
                
                
                —
 
 
 *(1)*
              *Consists
                  of operating leases for our facilities and for vehicles.*
  *(2)*
              *Consists
                  of purchase orders for components for our products that have not
                  been
                  received by us. In some cases, we are entitled to terminate our
                  commitment
                  upon 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 $8.1
                  million had
                  been invested by December 31, 2007) 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.**In
                  February 2008, we sold approximately 52% of our investment thus
                  reducing
                  the commitment accordingly.*
  The
        table
        does not include obligations for accrued severance pay under Israel’s Severance
        Pay Law, 1963, which as of December 31, 2007 was $4.8 million, of which
        $3.9 million was funded through deposits into severance pay funds, leaving
        a net
        obligation of $900,000. In addition, the table does not include obligations
        for
        unrecognized tax benefits of $2.5 million as of December 31,
        2007.
  **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
              
              45
              
              Chairman
                  of the Board and Chief Executive OfficerAviram
                  Shemer
              
              38
              
              Chief
                  Financial OfficerElinor
                  Nissensohn
              
              34
              
              Vice
                  President, Global Sales and MarketingDavid
                  Assia (1)
              
              56
              
              DirectorMenahem
                  Gutterman (1)(2)
              
              68
              
              DirectorOrna
                  Berry (1)(2)
              
              58
              
              DirectorDany
                  Margalit
              
              41
              
              Director
 
 *(1)*
              *Member
                  of the audit committee and independent director under the Nasdaq
                  Global
                  Market listing requirements.*
  *(2)*
              *Outside
                  director under the Israeli Companies
                  Law.*
  42
  *Jacob
        (Yanki) Margalit* founded
        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.
  *Aviram
        Shemer* was
        appointed as our chief financial officer in January 2007. During 2006, Mr.
        Shemer served as the chief financial officer of PowerDsine Ltd., a developer
        of
        power over ethernet (PoE) solutions recently acquired by Microsemi Corporation.
        In 2006, Mr. Shemer also served as vice president, finance of Alvarion Ltd.,
        a
        provider of wireless broadband solutions and specialized mobile networks.
        From
        1999 until 2005, Mr. Shemer served at Aladdin in various positions, including
        serving as vice president, finance in 2005. Mr. Shemer holds a B.A. in
        accounting and economics and an MBA with a specialization in finance and
        accounting from Tel Aviv University **.**
  *Elinor
        Nissensohn* has
        served as our global vice president of sales and marketing since July 2006.
        Ms.
        Nissensohn began working in our company in January 2003 as our business
        development manager. In July 2004, she was appointed as our customer relations
        manager and in March 2005, Ms. Nissensohn became vice president of customer
        relations. Ms. Nissensohn had previously worked for IBM Corp., Bezeq - Israel
        Telecommunications Company, the leading Israeli phone service provider, and
        Motorola Semiconductor. Ms. Nissensohn holds an LLB from Tel Aviv University
        and
        an MBA from Columbia Business School. Ms. Nissensohn is also admitted to
        the
        Israeli Bar.
 
 *David 
        Assia* has
        served as a director since 1993. Mr. Assia is a co-founder of
        Magic Software Enterprises Ltd., or Magic, a provider of development and
        integration technology, and of Formula Vision Technologies (F.V.T.) Ltd., a
        software holding company.  From 1983 to 1996 and from 2005 until 2007, Mr.
        Assia served as the chief executive officer and chairman of the board of
        directors of Magic. Mr. Assia is also a member of the boards of directors
        of
        Radview Software Ltd., a developer of verification software, RRSat Global
        Communications Network Ltd., a provider of end to end transmission services
        to
        the television and radio industries, 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 Gutterman* has
        served as one of our outside directors 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, Dr. Gutterman was a senior managing partner of Atid Capital
        Partners, an American/Israeli venture capital fund. Dr. Gutterman served
        as
        executive vice president and head of the operations information systems division
        of Israel Discount Bank Ltd. from 1992 until 2001. 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 Berry* has
        served as one of our outside directors since 2001. Dr. Berry is a venture
        partner in Gemini Israel Funds Ltd. Since January 2007, Dr. Berry has served
        as
        the chairperson of the Israel Venture Capital Association (IVA) and since
        2005
        she has chaired Prime Sense Ltd.  Dr. Berry serves as an external
        director of a number of publicly traded companies. Dr. Berry served as the
        Chief
        Scientist of the Ministry of Industry and Trade of the Government of Israel
        from
        1997 to 2000. From 1993 until 1997, Dr. Berry was a co-president of Ornet
        Data
        Communications Technologies Ltd., a provider of high-speed switches, which
        was
        acquired by Siemens AG. During 1992 and 1993, Dr. Berry served as a researcher
        in both IBM and Unisys and had a fellowship at the Rand Corporation during
        her PhD studies. 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
        Margalit* joined
        our company in 1987 as a research and development manager and has served
        as a
        director since 1994. In 1989, Mr. Margalit was appointed executive vice
        president, research and development and served in this position until 1998.
        From
        1998 until April 2006, Mr. Margalit served as our executive vice president,
        technologies. Since April 2006, Mr. Margalit has served as an advisor to
        our
        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.
  43
  **B.****Compensation**
  For
        the
        year ended December 31, 2007, we paid in the aggregate approximately $1.8
        million as direct remuneration to our directors and executive officers. This
        amount includes directors’ fees and expenses and amounts set aside or accrued to
        provide pension, social security or similar benefits. This amount does not
        include amounts expended by us for automobiles made available to our officers,
        expenses reimbursed to officers (including business travel, professional
        and
        business association dues and expenses) and other fringe benefits commonly
        reimbursed or paid by companies in Israel.
 
 The
        compensation paid to our directors, including to our directors who also serve
        as
        executive officers, is subject to the approval of our audit committee, board
        of
        directors and shareholders.
 
 *Outside
        Directors.* We
        reimburse our outside directors at the maximum amount permitted under the
        Companies Regulations (Rules for the Payment of Remuneration and Expenses
        of
        Outside Directors) 2002, which include the following amounts:
  (i)
              an
                  annual cash remuneration of NIS 42,245;
                  and
  (ii)
              participation
                  fees of NIS 1,625 for every meeting of the board of directors or
                  its
                  committees in which the outside directors participate.
  The
        above
        mentioned amounts are linked to the Israeli consumer price index in accordance
        with the Companies Regulations.
 
 In
        addition, until December 2007, we granted to each of our outside directors
        options to purchase 12,000 ordinary shares under the Company's Worldwide
        2003
        Share Option Plan, for each three-year term of service. The exercise price
        per
        share equaled the closing price of our ordinary shares on the Nasdaq Global
        Market on the last day of trading prior to the approval of the grant by the
        shareholders meeting. The options vest in three installments at the end of
        each
        of the three years of service, subject to the outside director’s continued
        service as an outside director at each of these dates. Our current policy
        is to
        discontinue these option grants
 
 *Non-employee
        directors.* We
        reimburse our non-employee directors, which currently include Mr. David Assia
        and Mr. Dany Margalit, in the same amounts approved for our outside directors.
  *Jacob
        (Yanki) Margalit* .
        Effective October 2002, we entered into an agreement with Jacob (Yanki)
        Margalit, our chairman and chief executive officer, which provides for an
        annual
        base salary of $150,000. Under his employment terms, 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. In addition, 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 2007, Mr. Margalit was granted a cash bonus in the amount
        of $379,000. 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 Global Market on the date of grant. One-third of the
        options became exercisable on each of the first three anniversaries of the
        date
        of grant. The options expire in April 2013. In accordance with Mr. Margalit's
        employment terms, Mr. Margalit also uses a company car and is entitled to
        25
        days of paid vacation per year, as well as other benefits commonly paid by
        companies in Israel.
 
 *Dany
        Margalit.* Dany
        Margalit served as our executive vice president, technologies, until April
        2006.
        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 Global Market on
        the
        date of grant. One quarter of the options became exercisable on each of the
        first four anniversaries of the date of grant. The options expire in December
        2013. As of April 2006, Mr. Margalit began providing our company with advisory
        services pursuant to an agreement entered into between him and us. Under
        the
        terms of the agreement, in consideration for these services, we pay him a
        monthly compensation of $6,000. In addition, we reimburse Mr. Margalit,
        currently a non-employee director of our company, in the same amounts payable
        to
        our outside directors.
  44


**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 outside directors, are 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 outside directors
        whose terms will expire pursuant to the Israeli Companies Law, 1999, hereinafter
        referred to as the Companies Law, as described under “—Outside Directors.” Other
        than Jacob (Yanki) Margalit, our chairman and chief executive officer, and
        Dany
        Margalit, a director, none of our directors are employed by us or are party
        to a
        service contract with us.
  At
        a
        general meeting, a simple majority of our shareholders may remove any of
        our
        directors from office (other than our outside directors), elect directors
        in
        their stead and fill any vacancy, however created, in our board of directors.
        In
        addition, vacancies on our board of directors, other than a vacancy created
        by
        an outside director, may be filled by a vote of a majority of the directors
        then
        in office (notwithstanding failure to meet the quorum requirement). 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.
  ***Outside
        and independent directors***
  Under
        the
        Companies Law, companies incorporated under Israeli Law, whose shares have
        been
        offered to the public in or outside of Israel, are required to appoint at
        least
        two outside directors. The Companies Law provides that a person may not be
        appointed as an outside director if such person or person’s relative, partner,
        employer or any entity under such person’s control, has, as of the date of such
        person’s appointment as an outside 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 outside director if such person’s position or other business
        activities create, or may create a conflict of interest with the person’s
        responsibilities as an outside director or may otherwise interfere with such
        person’s ability to serve as an outside director or if such person is an
        employee of the Israel Securities Authority or of an Israeli stock exchange.
        If,
        at the time of election of an outside director, all other directors are of
        the
        same gender, the outside director to be elected must be of the other gender.
        Outside directors are elected by a majority vote at a shareholders meeting,
        provided that either:
  (1)
              the
                  shares voting in favor of such resolution include at least one-third
                  of
                  the shares voted by shareholders who are not controlling shareholders;
                  or
  (2)
              the
                  total number of shares voted against the resolution by shareholders
                  who
                  are not controlling shareholders does not exceed one percent of
                  our
                  outstanding shares.
  Pursuant
        to the Companies Law, an outside director must have financial and accounting
        expertise or professional qualifications, provided that at least one outside
        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.
  45
  The
        initial term of an outside director is three years and may be extended for
        an
        additional three year term. Under a recent amendment to the Israeli Companies
        Regulations (Alleviation for Public Companies Whose Shares are Listed on
        a Stock
        Exchange Outside of Israel) 2000, dual listed companies, like us, may appoint
        an
        outside director for additional three-year terms, above the maximum six-year
        term permitted under the Companies Law, if the audit committee and the board
        of
        directors confirm that due to the expertise and special contribution of the
        outside director to the work of the board and its committees, his or her
        re-appointment is in the best interests of the company. On December 31, 2007,
        Dr. Orna Berry was re-appointed as an outside director for a third three-year
        term, ending December 31, 2010. In December 2006, Dr. Menahem Gutterman was
        appointed as an outside director for a third three-year term, ending December
        31, 2009.
  Each
        committee exercising the powers of the board of directors is required to
        include
        at least one outside director. However, the audit committee must include
        all the
        outside directors.
  An
        outside 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 outside director.
  In
        addition to the requirements of the Israeli law, we comply with the Nasdaq
        Global Market listing requirements and the rules and regulations promulgated
        by
        the Securities and Exchange Commission, or the SEC, pursuant to which our
        board
        of directors must consist of a majority of 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 a criterion defined in
        regulations promulgated under the Companies Law, which became effective in
        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.
  ***Audit
        committee***
  The
        board
        of directors of an Israeli public company must appoint an audit committee
        comprised of at least three directors, which must include all of the company’s
        outside directors. The chairman of the board, any controlling shareholder,
        any
        relative of a controlling shareholder or any director which is employed or
        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 Global Market
        listing requirements and the rules and regulations promulgated by the SEC,
        we
        are required to have an audit committee consisting solely of independent
        directors who are financially literate, 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.
        We believe that Mr. Assia qualifies as a financial expert under the SEC and
        NASDAQ 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.
  46
  ***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 its 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 external auditor 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 accordance with the
        Nasdaq
        Marketplace Rules, each of our compensation and nominating committees adopted
        a
        charter which sets forth each committee’s responsibilities. Pursuant to its
        charter, the compensation committee is 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 share option
        plans. The nominating committee is responsible for recommending to the board
        of
        directors nominees for board membership. Each charter requires that the
        composition of such committee satisfy the independent director requirements
        of
        the Nasdaq Marketplace Rules.
  **D.****Employees**
  As
        of
        December 31, 2007, we and our subsidiaries had 464 employees, 269 of whom
        were based in Israel, 117 in Europe, 63 in the United States, 12 in Japan
        and
        Asia and 3 in India.
  The
        following table sets forth for the last three fiscal years the breakdown
        of our
        employees by activity:
  **As
                  of December 31,****2005**
              
              ******2006**
              
              ******2007**ActivityOperations
                  , logistics and manufacturing
              
              
              58
              
              
              70
              
              
              72Research
                  and development
              
              
              163
              
              
              174
              
              
              176Marketing
                  and sales
              
              
              92
              
              
              111
              
              
              136Administration
                  and management
              
              
              87
              
              
              85
              
              
              80**Total**
              
              
              **400**
              
              
              **440**
              
              
              **464**
  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.
  47
  **E.****Share
        Ownership**
  All
        of
        the persons listed above, under the caption “Directors and Senior Management”
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
        March 1, 2008, Jacob (Yanki) Margalit beneficially owned 1,858,549 ordinary
        shares, representing 13.3% of our outstanding share capital, and Dany Margalit
        owned 924,195 ordinary shares, representing 6.6% of our outstanding share
        capital. Information regarding our share option plans presented in Note 14(e)
        to
        our consolidated financial statements is incorporated herein by reference.
  Between
        1993 and 2007, we implemented several employee share options plans. A total
        of
        3,773,750 ordinary shares are authorized for issuance under the plans. As
        of
        December 31, 2007, options to purchase an aggregate of 434,174 ordinary shares
        were still available for future grants. Under the plans, full-time employees,
        officers and directors of our company may be granted options to purchase
        ordinary shares. The options granted are at an exercise price that equals
        the
        fair market value or the price 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.
 
 In
        January 2007, our board of directors approved an amendment to our Worldwide
        2003
        Share Option Plan pursuant to which we are authorized to grant to employees
        restricted share units (in addition to options to purchase shares initially
        authorized under the plan) in accordance with the terms of the plan. As of
        March
        1, 2008 we have not yet granted to our employees restricted share units under
        the plan.
  **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, as recorded in schedules 13G, 13G/A
                  and 13D
                  published with the SEC to date; and
  ·
              all
                  of our directors and executive officers as a group.
  We
        have
        determined beneficial ownership in accordance with the rules of the SEC.
        Unless
        indicated otherwise, to our knowledge, the persons and entities named in
        the
        table below have sole voting and sole dispositive power with respect to all
        shares beneficially owned, subject to community property laws where applicable.
        Share 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 such options for the purpose of computing the percentage
        ownership of the beneficial owner of such options, 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., 35 Efal Street, Kiryat Arye, Petach Tikva
        49511,
        Israel.
  48
  The
        percentage of shares beneficially owned is based on 13,863,858 ordinary shares
        outstanding as of March 1, 2008, and excludes 928,697 shares which were
        purchased under our buy-back program and are held by Aladdin. Pursuant to
        Israeli law, the shares held by Aladdin do not confer upon Aladdin any rights.
        For more information about our buy back program, see “Item 5.B. Liquidity and
        Capital Resources” above.
 **Name**
                **Number
                    of Shares**
                  **Beneficially
                    Owned**
                **Percent
                    of**
                  **Outstanding
                    Shares**Juniper
                    Trading Services, Inc.(1)
                2,104,700
                15.2%Jacob
                    (Yanki) Margalit(2)
                1,858,549
                13.3%Galleon
                    Advisors, L.L.C.(3)
                1,641,740
                11.8%BlackRock,
                    Inc.(4)
                993,272
                7.2%FMR
                    Corp.(5)
                1,273,200
                9.2%Manning
                    & Napier Advisors Inc.(6)
                1,131,793
                8.2%Dany
                    Margalit(7)
                924,195
                6.6%All
                    directors and executive officers as a group (7 persons)(8)
                2,843,344
                20.2%
  ___________
 (1)
          Based
          on a Schedule 13D filed on September 29, 2000. The address of Juniper Trading
          Services, Inc. is Compass Point Building, 9 Bermudiana Road, Bermuda.
 (2)
          Based
          on a Schedule 13G/A filed on February 14, 2008.
 (3)
          Based
          on a Schedule 13G/A filed on February 15, 2006. The beneficial ownership
          indicated above represents the aggregate beneficial ownership of Galleon
          Advisors, KKC, Galleon Management, LLC, Galleon Management, LP, Galleon
          Captain's Partners, LP, Galleon Captain's Offshore, LTD, Galleon Technology
          Partner II, LP, Galleon Technology Offshore, LTD., Galleon Explorers Partners,
          LP, 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.
 (4)
          Based
          on a Schedule 13G filed on February 8, 2008. The beneficial ownership indicated
          above represents the beneficial ownership of BlackRock Inc. on behalf of
          the
          following investment advisory subsidiaries of BlackRock, Inc.: BlackRock
          Advisors LLC, BlackRock Asset Management UK Ltd., BlackRock Capital
          Management, Inc., BlackRock Investment Management LLC, BlackRock Financial
          Management, Inc., BlackRock Japan Co. Ltd. and State Street Research &
Management Co. BlackRock, Inc. is located at 40 East 52nd Street, New York,
          NY
          10022.
 (5)
          Based
          on Schedule 13G filed on February 14, 2007. The beneficial ownership indicated
          above represents the aggregate beneficial ownership of FMR Corp. and Fidelity
          International Limited, parent companies of various investment advisors
          that
          manage institutional accounts and open-end investment companies. FMR Corp.
          is
          located at 82 Devonshire Street, Boston, Massachusetts, and Fidelity
          International is located at P.O. Box 670, Hamilton, HMCX, Bermuda.
 (6)
          Based
          on a Schedule 13G filed on February 8, 2008. Manning & Napier Advisors Inc.
          is located at 290 Woodcliff Drive, Fairport, NY 14450.
 (7)
          Based
          on a Schedule 13G/A filed on February 14, 2008.
 (8)
          Consists of 2,617,744 ordinary shares and options to purchase 225,600 Ordinary
          Shares
 To
        our
        knowledge, the significant changes in the percentage of ownership held by
        any
        major beneficial shareholders during the past three years have been the decrease
        in the percentage of ownership held by FMR Cor p
        (from
        14.7% to 9.2% as of February 14, 2007) and the sale by Tracer Capital Management
        of its entire shareholdings in the company.
  The
        voting rights of our major shareholders do not differ from the voting rights
        of
        other holders of our ordinary shares, except for Aladdin which has no voting
        rights with respect to the shares held by it.
 
 As
        of
        March 1, 2008, there were a total of 49 holders of record of our outstanding
        ordinary shares, of which 32 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.
  49
  **B.****Related
        Party Transactions**
  ***Directors
        Fees***
  We
        pay
        directors fees in respect of service by our non-employee directors (including
        outside directors). For more information, see “Item 6.B. Directors, Senior
        Management and Employees - Compensation.”
  ***Agreements
        with Directors and Officers***
  *Employment
        agreements*
  We
        maintain written employment agreements with all of our officers. In addition,
        we
        entered into a written agreement with Dany Margalit, a director and advisor
        of
        our company. For more information regarding the compensation of our officers
        and
        directors, see “Item 6.B. Directors, Senior Management and Employees -
        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 SEC, such
        indemnification of directors and officers for liabilities arising under the
        Securities Act of 1933, as amended, referred to as 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 submitted
        under this policy.
  For
        more
        information about indemnification and insurance of our directors and officers,
        see Item 10.B. Memorandum and Articles of Association - Exculpation, insurance
        and indemnification of directors and officers.”
  ***Transactions
        with an affiliate***
  In
        October 2006, we entered into a license agreement with Athena. Pursuant to
        this
        agreement Athena granted Aladdin a worldwide perpetual non revocable,
        transferable, non-exclusive license to use any intellectual property rights,
        including without limitation patents, trade secrets, trademarks and copyrights
        in the licensed software for the amount of $250,000. Aladdin can solely use
        the
        license and market, sublicense, distribute and sell it as embedded in or
        integrated with Aladdin products.
  In
        addition, we purchase from Athena certain components and Athena provides
        us with
        certain research and development services.
  **C.****Interests
        of Experts and Counsel**
  Not
        applicable.
  **Item
                  8.**
              **FINANCIAL
                  INFORMATION**
  **A.****Consolidated
        Statements and Other Financial Information**
  The
        financial statements required by this item are found at the end of this annual
        report, beginning on page F-1.
  50
  ***Legal
        Proceedings***
  We
        are
        not involved in any proceedings in which any of our directors, members of
        our
        senior management or any of our affiliates is either a party adverse to us
        or to
        our subsidiaries or has a material interest adverse to us or to our
        subsidiaries. We are also not involved in any material legal proceedings,
        except
        as described below.
  We
        submitted claims in the U.S. District Court for the District of Delaware
        (the
        "District Court") 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 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, acknowledging
        that
        certain products manufactured or distributed by Feitian infringe those patents,
        and agreed to cease to import, distribute, sell, or offer to sell in or into
        the
        United States any products that infringe these patents. Feitian and several
        other defendants moved to dismiss the case on the basis that the court 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
        allowed us to proceed with the discovery to support our claim that the court
        has
        jurisdiction over Feitian and RS-Computer. Upon the completion of the discovery,
        we filed a supplemental brief with the court concerning the jurisdictional
        issues. On February 19, 2008, the District Court held that personal jurisdiction
        exists in Illinois and ordered, among other things, that the action be
        transferred to the United States District Court for the Northern District
        of
        Illinois. We intend to vigorously pursue our claims. At this stage, we cannot
        predict the outcome of the proceedings.
  ***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 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, 2007.
  **Item
                  9.**
              **THE
                  OFFER AND LISTING**
  **A.****Offer
        and Listing Details**
  On
        March
        1, 2008, the last reported sale price of our ordinary shares on the Nasdaq
        Global Market was $21.2 per share.
  51
  The
        table
        below sets forth the high and low closing sales prices of our ordinary shares,
        as reported by the Nasdaq Global Market during the periods indicated:
  **Annual**
                
                **High**
                
                **Low**2007
                
                $
                26.57
                
                $
                16.832006
                
                
                23.57
                
                
                13.722005
                
                
                25.40
                
                
                15.952004
                
                
                32.12
                
                
                8.732003
                
                
                10.10
                
                
                2.25**Quarterly**First
                    Quarter 2008 (through March 1, 2008)
                
                $
                26.02
                
                $
                17.98Fourth
                    Quarter 2007
                
                
                26.57
                
                
                22.40Third
                    Quarter 2007
                
                
                23.29
                
                
                20.63Second
                    Quarter 2007
                
                
                22.78
                
                
                16.89First
                    Quarter 2007
                
                
                19.53
                
                
                16.83Fourth
                    Quarter 2006
                
                
                19.49
                
                
                16.52Third
                    Quarter 2006
                
                
                20.35
                
                
                13.72Second
                    Quarter 2006
                
                
                23.57
                
                
                19.15First
                    Quarter 2006
                
                
                22.49
                
                
                16.81**Most
                    Recent Six Months**February
                    2008
                
                $
                22.64
                
                $
                19.92January
                    2008
                
                
                26.02
                
                
                17.98December
                    2007
                
                
                26.57
                
                
                25.63November
                    2007
                
                
                26.18
                
                
                23.33October
                    2007
                
                
                24.81
                
                
                22.40September
                    2007
                
                
                22.38
                
                
                20.79
  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:
  **Annual**
                
                **High**
                
                **Low**2007
                
                
                NIS
                    104.50
                
                
                NIS
                    70.602006
                
                
                108.30
                
                
                60.832005
                
                
                112.40
                
                
                73.882004
                    (since July, 28, 2004)
                
                
                137.80
                
                
                69.47**Quarterly**First
                    Quarter 2008 (through March 1, 2008)
                
                
                NIS
                    102.90
                
                
                NIS
                    66.21Fourth
                    Quarter 2007
                
                
                104.50
                
                
                89.96Third
                    Quarter 2007
                
                
                97.94
                
                
                85.01Second
                    Quarter 2007
                
                
                91.78
                
                
                70.78First
                    Quarter 2007
                
                
                82.15
                
                
                70.60Fourth
                    Quarter 2006
                
                
                80.37
                
                
                70.23Third
                    Quarter 2006
                
                
                89.90
                
                
                60.83Second
                    Quarter 2006
                
                
                108.30
                
                
                86.22First
                    Quarter 2006
                
                
                103.90
                
                
                77.51**Most
                    Recent Six Months**February
                    2008
                
                
                NIS
                    81.34
                
                
                NIS
                    72.89January
                    2008
                
                
                102.90
                
                
                66.21December
                    2007
                
                
                104.50
                
                
                99.59November
                    2007
                
                
                97.40
                
                
                91.05October
                    2007
                
                
                100.30
                
                
                89.96September
                    2007
                
                
                89.57
                
                
                85.01
  As
        of
        March 1, 2008, the exchange rate of the NIS to the U.S. dollar was
        $1=NIS 3.635.
  52
  **B.****Plan
        of Distribution**
  Not
        applicable.
  **C.**  **Markets**
  The
        primary **** trading
        market for our ordinary shares is the Nasdaq Global 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.”
  Pursuant
        to NASDAQ Marketplace Rule 4350(a)(1), we received an exemption from Marketplace
        Rule 4350(i)(1), which requires a company to seek shareholder approval prior
        to
        the issuance of securities. For issuances of securities, we obtain the approval
        of our board of directors and in certain circumstances, we also obtain the
        approval of our audit committee or share option compensation committee. Our
        practices comply with Israeli law and practice.
 
 **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**
  We
        are
        registered with the Israeli Companies Register under the number 52-004003-1.
        Our
        objects are specified in section 5 of our articles of association and include
        engaging in any lawful act or activity for which companies may be organized
        under the Companies Law.
  53
  ***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 or her 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 6A under “Directors and
        Senior Management” is an office holder. Under the Companies Law, arrangements
        regarding the compensation of directors (whether in their capacity as directors
        or in any other position in the company) require the approval of the audit
        committee, the board of directors and shareholders. Arrangements regarding
        compensation of officers who do not serve as directors, require the approval
        of
        the audit committee and the board of directors.
 
 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
        or
        act 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 of 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
        of 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 conducted not in the ordinary course of business,
        not
        on market terms or that is likely to have a material impact on the company’s
        profitability, assets or liabilities.
 
 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 such meeting or vote on such matter. However,
        if
        the majority of the board members or members of the audit committee, as
        applicable, have a personal interest in such matter, they may all participate
        in
        the discussion and vote thereon, but the matter shall also be subject to
        shareholder approval.
 
 The
        Companies Law applies the same disclosure requirements to a controlling
        shareholder of a public company. The term “controlling shareholder” includes 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; alternatively, the
        total
        shareholdings of those who have no personal interest in the transaction and
        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 issuedrepresent 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 securitieslistedon
                  a recognized stock exchange, or is not at a fair market value;
                  or
  54
  ·
              a
                  person would become, as aresultof
                  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
        currently have only one class of securities outstanding, 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 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. A 21-day prior written notice shall be given to our
        shareholders with respect to every shareholders meeting. In some instances
        specified in regulations promulgated under the Companies Law, a 35-day prior
        notice should be given of a shareholders meeting. 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, at the same day, 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 a simple majority. No further
        notice of the adjourned meeting is required to be given. 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 expressly provided in the terms of issuance of the shares
                  as
                  mentioned above);
  ·
              appointment
                  or dismissal of our auditors;
  ·
              appointment
                  of directors;
  55
  ·
              approval
                  of acts and transactions requiring general meeting approval under
                  the
                  Companies Law;
  ·
              increase
                  or reduction of our authorized share capital or change of 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 its 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.
  Our
        board
        of directors is authorized to declare dividends, subject to the provisions
        of
        the Companies Law. Dividends on our ordinary shares may be paid only out
        of
        profits and other surplus, as defined in the Companies Law, as of the end
        date
        of the most recent financial statements or as accrued over a period of two
        years, whichever is higher. Alternatively, if we do not have sufficient profits
        or other surplus, then permission to effect a distribution can be granted
        by
        order of an Israeli court. In any event, our board of directors is authorized
        to
        declare dividends, provided there is no reasonable concern that the dividend
        will prevent us from satisfying our existing and foreseeable obligations
        as they
        become due. Dividends may be paid in cash or in kind.
  ***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.
  *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.
  56
  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 competent court; (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 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 certain circumstances defined in the Companies
        Law as described below.
  *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:
  ·
              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.
  These
        limitations are included in our articles of association.
  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.
  57
  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 45%
        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.
  **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.
  58
  **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; (ii) such gains did not derive from a
        permanent establishment of such shareholders in Israel; and (iii) such gains
        were not subject to the provisions of the Inflationary Adjustments Law. 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 to the provisions of the
        Inflationary Adjustments Law, prior to the publishing of amendment no. 147
        to
        the Income Tax Ordinance, in 2005), selling our ordinary shares are subject
        to a
        25% tax rate on any real capital gain. Israeli corporate 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.
  59
  *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. In order to obtain such a reduced tax rate, it
        is
        necessary to submit an application to the tax assessing officer.
 
 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:
  ·
              an
                  individual who is a citizen or resident of the United States for
                  U.S.
                  federal income tax purposes;
  ·
              a
                  corporation (or other entity taxable as a corporation for U.S.
                  federal
                  income tax purposes) created or organized under the laws of the
                  United
                  States or any political subdivision thereof or the District of
                  Columbia;
  ·
              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. Unless otherwise specifically indicated, this discussion does not
        consider the U.S. federal income tax consequences to a person that is a non-U.S.
        holder of our ordinary shares and considers only U.S. holders that will own
        the
        ordinary shares as capital assets (generally for investment).
  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.
  60
  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
        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 the U.S. federal income tax consequences to U.S. holders who are
        broker-dealers or who own, directly, indirectly or constructively, 10% or
        more
        (by voting power) of our company, real estate investment trusts, regulated
        investment companies, 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 that receive ordinary shares
        as
        compensation for the performance of services, certain former citizens or
        long-term residents of the United States 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, including the amount of any non-US taxes withheld, 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. Dividends that are received with respect to
        ordinary shares by U.S. holders that are individuals, estates or trusts
        generally will be taxed at the rate applicable to long-term capital gains
        (currently a maximum rate of 15% for the taxable years beginning on or before
        December 31, 2010), 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 taxable year, dividends
        paid on our ordinary shares in such year or in the following taxable 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.
  61
  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 non-U.S. 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 non-U.S. 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 generally
        will
        be foreign source “passive income” for U.S. foreign tax credit purposes. U.S.
        holders that do not elect to claim a foreign tax credit may instead claim
        a
        deduction for the non-U.S. 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 non-U.S.
        income taxes 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 generally
        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 (long-term capital gains are currently taxable at a maximum
        rate
        of 15% for taxable years beginning on or before December 31, 2010). 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 generally
        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, which will generally be
        U.S.
        source ordinary income of loss.
  62
  **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.
  We
        believe that we were not a PFIC for our 2007 taxable year. Our status in
        the
        current and future taxable 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 certain 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
        with
        respect to, and proceeds from the disposition of, the ordinary shares. Backup
        withholding will not apply with respect to payments made 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 will not be subject
        to U.S.
        federal income or withholding, in the case of U.S. Federal income taxes,
        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 on
        the
        disposition of the ordinary shares will be subject to tax in the United States
        if such 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 are generally not subject to information reporting or backup withholding
        with respect to the payment of dividends on, or proceeds from the disposition
        of, ordinary shares, provided that the non-U.S. holder provides its taxpayer
        identification number, certifies to its foreign status or otherwise establishes
        an exemption.
  63
  **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 Exchange
        Act 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
        of
        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 100 F Street, N.E., 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
        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
        this annual report, 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.
  ***Foreign
        exchange risk***
  Although
        we report our consolidated financial statements in U.S. dollars, in 2007
        a
        portion of our revenues and expenses was denominated, in other currencies.
        We
        derived approximately 50% of revenues in U.S. dollars, 37% in euros, 7% in
        Japanese yen and 6% in British pounds. In 2007, 59% of our expenses were
        denominated in U.S. dollars, 23% in NIS, 13% in euros, 3% in Japanese yen
        and 3%
        in British pounds. Exchange differences upon translation from the functional
        currency of our German and Spanish subsidiaries, which is the euro, to the
        dollar, are accumulated as a separate component of accumulated other
        comprehensive loss under shareholders’ equity. As of December 31, 2007,
        accumulated other comprehensive loss decreased by $318,000 compared to
        December 31, 2006. As of December 31, 2006, accumulated other
        comprehensive loss increased by $441,000 compared to December 31, 2005.
        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.
  The
        following table illustrates the effect of the changes in exchange rates on
        our
        revenues, gross profit and income from operations for the periods
        indicated:
 **Year
                    ended December 31,**
                ********
                ****
                **2005**
                ****
                **2006**
                ****
                **2007**
                ********
                ****
                **Actual**
                ****
                **At
                    2004 Exchange**
                  **rates
                    (1)**
                ****
                **Actual**
                ****
                **At
                    2005 Exchange**
                  **rates
                    (1)**
                ****
                **Actual**
                ****
                **At
                    2006 Exchange**
                  **rates
                    (1)**(In
                    thousands)Revenues
                
                $
                81,773
                
                $
                81,874
                
                $
                89,038
                
                $
                89,368
                
                $
                105,882
                
                $
                102,092Gross
                    profit
                
                
                64,802
                
                
                64,903
                
                
                69,025
                
                
                69,345
                
                
                78,552
                
                
                75,166Income
                    from operations
                
                
                12,550
                
                
                12,689
                
                
                13,206
                
                
                13,463
                
                
                13,911
                
                
                13,703
 (1)
        Based
        on average exchange rates during the period
  64
  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, 2007, we held
        one euro forward contract in a nominal amount of 570,000 euros, one British
        pound forward contract in a nominal amount of 275,000 British pounds, one
        Japanese Yen forward contract in a nominal amount of 275 million Japanese
        yen
        and one New Israeli Shekel forward contract in a nominal amount of NIS 12.5
        million. We recognized net gains from derivative instruments of $277,000
        during
        2007.
  ***Equity
        Investments***
  As
        of
        December 31, 2007, we invested approximately $8.1 million in two related
        private investment funds managed by Tamir Fishman Ventures Management II
        Ltd. Each of these funds invests primarily in securities of privately-held
        technology companies in Israel. In 2002, we recognized an impairment charge
        of
        $1.0 million related to these investments and we may recognize additional
        impairment charges in the future. We have a commitment to invest an additional
        $200,000 in these entities. In April 2006 and in April 2005, as a result
        of exit
        transactions for portfolio companies managed by Tamir Fishman Ventures
        Management II Ltd., we received cash proceeds of $1.7 million and $910,000,
        respectively. The proceeds from these distributions received in 2005 and
        2006
        were recorded as a return of investment.
  In
        February 2008, we sold approximately 52% of our investment in the investment
        funds managed by Tamir Fishman. The consideration was $2.9 million and the
        net
        gain was $614,000. We expect to sell the remainder of this investment during
        2008.
  ***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. We invest
        in
        U.S. government bonds with maturities of up to two years.
  Due
        to
        the short-term maturities of these investments, their carrying value
        approximates the fair value.
  **Item
                  12.**
              **DESCRIPTION
                  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.
  65
  **Item
        15.****CONTROLS
        AND PROCEDURES**
  (a) *Disclosure
        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) and Rule 15d-15(e) promulgated under the Exchange Act) as of
        December 31, 2007, 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.
  (b) *Management
        Annual Report on Internal Control over Financial Reporting* .
        Our
        board of directors and audit committee are responsible for establishing and
        maintaining adequate internal control over financial reporting. Our internal
        control system was designed to provide reasonable assurance regarding the
        reliability of financial reporting and the preparation and fair presentation
        of
        our consolidated financial statements for external purposes in accordance
        with
        generally accepted accounting principles.
  Our
        chief
        executive officer and chief financial officer assessed the effectiveness
        of our
        internal control over financial reporting (as defined in Rule 13a-15(f) and
        Rule
        15d-(f) promulgated under the Exchange Act) as of December 31, 2007. In making
        this assessment, they used the criteria established in Internal Control -
        Integrated Framework issued by the Committee of Sponsoring Organizations
        of the
        Treadway Commission (COSO). Based on this assessment, our chief executive
        officer and chief financial officer have concluded that, as of December 31,
        2007, our internal control over financial reporting is effective based on
        those
        criteria.
  Notwithstanding
        the foregoing, all internal control systems, no matter how well designed,
        have
        inherent limitations. Therefore, even those systems determined to be effective
        may not prevent or detect misstatements and can provide only reasonable
        assurance with respect to financial statement preparation and presentation.
        Also, projections of any evaluation of effectiveness to future periods are
        subject to the risk that controls may become inadequate because of changes
        in
        conditions, or that the degree of compliance with the policies or procedures
        may
        deteriorate.
  (c) *Attestation Report of the Registered Public Accounting Firm* .
        The
        attestation report of our registered public accounting firm is included in
        page
        F-2 of our audited consolidated financial statements set forth in “Item 18.
        Financial Statements,” and is incorporated herein by reference.
  (d) *Changes
        in Internal Control over Financial Reporting.* During
        the period covered by this annual report, there were no changes in our internal
        control over financial reporting 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
        under
        the NASDAQ Marketplace Rules, qualifies as an audit committee financial expert
        under NASDAQ and SEC rules.
  66
  **Item
                  16B.**
              **CODE
                  OF ETHICS**
  We
        have
        adopted a code of ethics that contains certain policies relating to ethical
        conduct of 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 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, 2007 and 2006, and fees billed for other services rendered by
        Ernst & Young LLP during the last two fiscal years.
  **2007**
                
                **2006**Audit
                    Fees(1)
                
                $
                286,660
                
                $
                226,649Audit-Related
                    Fees(2)
                
                $
                63,972
                
                $
                51,591Tax
                    Fees(3)
                
                $
                137,378
                
                $
                202,290All
                    Other Fees(4)
                
                $
                162,273
                
                $
                8,715**Total**
                
                **$**
                **650,283**
                
                **$**
                **489,245**
 
 (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.
  (2)
              Audit-related
                  fees are fees principally for services that are reasonably related
                  to the
                  performance of the audit or review of the company’s financial statements,
                  including: review of financial statements included in our quarterly
                  reports, and consultations concerning financial accounting and
                  reporting
                  standards.
  (3)
              Tax
                  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 services fees
                  also
                  include fees relating to other tax advices, tax consulting and
                  planning
                  other than for tax compliance and preparation.
  (4)
              All
                  other fees consist of fees relating to the implementation of the
                  SOX
                  regulations.
 
 Our
        audit
        committee has adopted a policy for pre-approval of audit and non-audit services.
        Under this policy, independent auditor proposed services either may be
        pre-approved without consideration of specific case-by-case services by the
        audit committee, referred to as a general pre-approval, or they may require
        the
        specific pre-approval of the audit committee, referred to as a 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.
  67
  **Item
                  16D.**
              **EXEMPTIONS
                  FROM THE LISTING STANDARDS FOR AUDIT
                  COMMITTEES**
  Not
        applicable.
  **Item
                  16E.**
              **PURCHASES
                  OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED
                  PURCHASERS**
 
 As
          further described below, during 2007, we spent an aggregate approximate
          amount
          of $20 million to repurchase approximately 1,000,000 of our shares. Pursuant
          to
          board authorizations in April and June, we were authorized to repurchase
          Ordinary Shares of the Company for an aggregate purchase price not to exceed
          $20
          million or for a maximum of 1,000,000 shares.
  Set
          forth below is a summary of the shares repurchased by us during 2007 and
          the
          maximum number of securities that may yet be purchased under the repurchase
          plan. No shares were repurchased in 2007 except during the months indicated
          and
          all shares were purchased in the open market.
 **Period**
                
                **Total
                    Number**
                  **of
                    Shares Purchased**
                
                **Average
                    Price Paid Per Share**
                
                **Total
                    Number**
                  **of
                    Shares Purchased as Part of Publicly Announced Plans**
                
                **Approximate
                    Dollar Amount That May Yet Be Purchased Under the Plan**May
                    2 -
                  May
                    31, 2007
                
                
                417,973
                
                $
                21.44
                
                
                417,973
                
                $
                1,058,916(1
                )June
                    4 -
                  June
                    6, 2007
                
                
                47,000
                
                $
                21.76
                
                
                47,000
                
                $
                30,568(1
                )July
                    20 -
                  July
                    30, 2007
                
                
                96,879
                
                $
                22.57
                
                
                96,879
                
                $
                7,846,605(2
                )August
                    1 -
                  August
                    28, 2007
                
                
                346,724
                
                $
                20.16
                
                
                346,724
                
                $
                471,828(2
                )September
                    7 -
                  September
                    13, 2007
                
                
                20,121
                
                $
                21.38
                
                
                20,121
                
                $
                41,701(2
                )
 
 (1)
                Amount
                    available for repurchase under our repurchase plan pursuant to
                    authorization by our board of directors in April 2007 to
                    repurchaseOrdinary Shares of the Company in an amount not to exceed $10,000,000
                    or a
                    maximum aggregate of 500,000 shares (the “Repurchase
                    Plan”).
 
 (2)
                Amount
                    available for repurchase under the Repurchase Plan, an increase
                    to which
                    was authorized by our board of directors in June 2007, so that
                    the
                    combined total authorization was $20 million or 1,000,000
                    shares.
 
 In
          November 2007, pursuant to authorizations by our board of directors, the
          Repurchase Plan was increased by $10 million, so that the combined total
          authorization was $30 million or a maximum aggregate of 1,500,000 shares.
          As of
          December 31, 2007, the Company had approximately $10 million remaining available
          pursuant to its repurchase authorization.
  **PART
        III.**
  **Item
                  17.**
              **FINANCIAL
                  STATEMENTS**
  Not
        applicable
  **Item
                  18.**
              **FINANCIAL
                  STATEMENTS**
  See
        our
        consolidated financial statements, following the signature page and
        certifications below.
 
 68
  **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)
 
 1.2
              Memorandum
                  of Association of the registrant.(2)(3)
 
 4
              Form
                  of Indemnification Agreement between the registrant and each of
                  the
                  members of its board of directors and its officers.(4)
 
 8
              List
                  of subsidiaries.*
 
 11
              Code
                  of Ethics(4)
 
 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.*
 
 15.1
              Consent
                  letter from Kost, Forer, Gabbay & Kasierer
                  *
 
 15.2
              Consent
                  letter from Blick Rothenberg *
 
 **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 2003 Annual Report on Form 20-F filed with
                  the
                  Commission on June 30, 2004.*
  69
  **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 Petach Tikva, State of Israel, on this 27th day
        of March 2008.
  **ALADDIN
                  KNOWLEDGE SYSTEMS LTD.**By:
              /s/
                  Jacob (Yanki) MargalitJacob
                  (Yanki) MargalitChief
                  Executive Officer andChairman
                  of the Board
  70
  **ALADDIN
          KNOWLEDGE SYSTEMS LTD. AND SUBSIDIARIES**
 
 **CONSOLIDATED
          FINANCIAL STATEMENTS**
 
 **AS
          OF DECEMBER 31, 2007**
 
 **IN
          U.S. DOLLARS**
  **INDEX**
  **Page**Reports
                    of Independent Registered Public Accounting Firm
                
                
                F-2Consolidated
                    Balance Sheetsas
                    of December 31, 2006 and 2007
                
                
                F-4Consolidated
                    Statements ofIncome
                    for the years ended December 31, 2005, 2006 and 2007
                
                
                F-6Statements
                    of Changes in Shareholders’ Equityas
                    of December 31, 2005, 2006 and 2007
                
                
                F-7Consolidated
                    Statements of Cash Flowsas
                    of December 31, 2005, 2006 and 2007
                
                
                F-8Notes
                    to Consolidated Financial Statements
                
                
                F-10Report
                    of Independent Registered Public Accounting Firm
                
                
                F-51
  
  F-1
  logo
  **REPORT
          OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 **To
          the Board of Directors and Shareholders of**
 
 **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 
 We
          have
          audited the accompanying consolidated balance sheets of Aladdin Knowledge
          Systems Ltd. ("the Company") and subsidiaries as of December 31, 2006 and
          2007,
          and the related consolidated statements of income, shareholders' equity
          and cash
          flows for each of the three years in the period ended December 31, 2007.
          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 Europe
          Ltd.,
          a wholly-owned U.K. subsidiary, which statements reflect total assets
          constituting 2% in 2006 and 1% in 2007, and total revenues constituting
          13% in
          2005, 7% in 2006 and 6% in 2007 of the related consolidated totals. These
          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
          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. An audit includes examining,
          on a
          test basis, evidence supporting the amounts and disclosures in the financial
          statements. An audit also includes assessing the accounting principles
          used and
          significant estimates made by management, as well as evaluating the overall
          financial statement presentation. We believe that our audits 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, 2006 and 2007, and the consolidated results of their operations
          and
          their cash flows for each of the three years in the period ended December
          31,
          2007, in conformity with U.S. generally accepted accounting
          principles.
 
 As
          discussed in Note 2 to the consolidated financial statements, the Company
          adopted the provision of Statement Financial Accounting Standards No. 123(R),
          "Share Based Payment", effective January 1, 2006.
 
 We
          also
          have audited, in accordance with the standards of the Public Company Accounting
          Oversight Board (United States), the Company and subsidiaries' internal
          control
          over financial reporting as of December 31, 2007, based on criteria established
          in Internal Control-Integrated Framework issued by the Committee of Sponsoring
          Organizations of the Treadway Commission and our report dated March 27,
          2008
          expressed an unqualified opinion thereon.
  
 Tel-Aviv,
                    Israel
                KOST
                    FORER GABBAY & KASIERERMarch
                    27, 2008
                A
                    Member of Ernst & Young Global
 
 F-2
 
 logo
 **REPORT
          OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 **To
          the Shareholders and Board of Directors of**
 
 **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 
 We
          have
          audited Aladdin Knowledge Systems Ltd’s (the "Company") and subsidiaries’
internal control over financial reporting as of December 31, 2007, based
          on
          criteria established in Internal Control-Integrated Framework issued by
          the
          Committee of Sponsoring Organizations of the Treadway Commission (the COSO
          criteria). The Company's management is responsible for maintaining effective
          internal control over financial reporting and for its assessment of the
          effectiveness of internal control over financial reporting included in
          the
          accompanying Management’s
          Annual Report on internal control over financial reporting .
          Our
          responsibility is to express an opinion on the Company's internal control
          over
          financial reporting based on our audit.
 
 We
          conducted our audit in accordance with the standards of the Public Company
          Accounting Oversight Board (United States). Those standards require that
          we plan
          and perform the audit to obtain reasonable assurance about whether effective
          internal control over financial reporting was maintained in all material
          respects. Our audit included obtaining an understanding of internal control
          over
          financial reporting, assessing the risk that a material weakness exists,
          testing
          and evaluating the design and operating effectiveness of internal control
          based
          on the assessed risk, and performing such other procedures as we considered
          necessary in the circumstances. We believe that our audit provides a reasonable
          basis for our opinion.
 
 A
          company's internal control over financial reporting is a process designed
          to
          provide reasonable assurance regarding the reliability of financial reporting
          and the preparation of financial statements for external purposes in accordance
          with generally accepted accounting principles. A company's internal control
          over
          financial reporting includes those policies and procedures that (1) pertain
          to
          the maintenance of records that, in reasonable detail, accurately and fairly
          reflect the transactions and dispositions of the assets of the company;
          (2)
          provide reasonable assurance that transactions are recorded as necessary
          to
          permit preparation of financial statements in accordance with generally
          accepted
          accounting principles, and that receipts and expenditures of the company
          are
          being made only in accordance with authorizations of management and directors
          of
          the company; and (3) provide reasonable assurance regarding prevention
          or timely
          detection of unauthorized acquisition, use, or disposition of the company's
          assets that could have a material effect on the financial
          statements.
 
 Because
          of its inherent limitations, internal control over financial reporting
          may not
          prevent or detect misstatements. Also, projections of any evaluation of
          effectiveness to future periods are subject to the risk that controls may
          become
          inadequate because of changes in conditions, or that the degree of compliance
          with the policies or procedures may deteriorate.
 
 In
          our
          opinion, the Company maintained, in all material respects, effective internal
          control over financial reporting as of December 31, 2007, based on the
          COSO
          criteria.
  We
          also
          have audited, in accordance with the standards of the Public Company Accounting
          Oversight Board (United States), the consolidated balance sheets of the
          Company
          and subsidiaries as of December 31, 2006 and 2007, and the related consolidated
          statements of income, shareholders' equity and cash flows for each of the
          three
          years in the period ended December 31, 2007 and our report dated March 27,
          2008 expressed an unqualified opinion thereon.
 
 
 Tel-Aviv,
                    Israel
                KOST
                    FORER GABBAY & KASIERERMarch
                    27,
                    2008
                A
                    Member of Ernst & Young Global
 
 F-3
  **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 **AND
          SUBSIDIARIES**
  **CONSOLIDATED
          BALANCE SHEETS**
 **U.S.
          dollars in thousands, except share and per share data**
  **December
                    31,****2006**
                
                **2007**ASSETSCURRENT
                    ASSETS:Cash
                    and cash equivalents
                
                $
                39,734
                
                $
                77,209Marketable
                    securities (Note 3)
                
                
                51,147
                
                
                13,127Investment
                    in other companies (Note 6)
                
                
                -
                
                
                4,423Trade
                    receivables (net of allowance for doubtful accounts - $ 274 and$
                    401 as of December 31, 2006 and 2007, respectively)
                
                
                16,427
                
                
                16,918Other
                    accounts receivable and prepaid expenses (Note 4)
                
                
                4,203
                
                
                5,414Inventories
                    (Note 5)
                
                
                7,299
                
                
                8,763Deferred
                    income taxes (Note 13)
                
                
                1,526
                
                
                1,647Totalcurrent assets
                
                
                120,336
                
                
                127,501LONG-TERM
                    INVESTMENTS:Investment
                    in other companies (Note 6)
                
                
                5,773
                
                
                1,305Severance
                    pay fund
                
                
                3,153
                
                
                3,853Totallong-term investments
                
                
                8,926
                
                
                5,158PROPERTY
                    AND EQUIPMENT, NET (Note 7)
                
                
                5,695
                
                
                6,501OTHER
                    ASSETSIntangible
                    assets, net (Note 8)
                
                
                4,045
                
                
                1,269Goodwill
                    (Note 9)
                
                
                7,685
                
                
                7,685Deferred
                    income taxes (Note 13)
                
                
                1,635
                
                
                1,619Prepaid
                    expenses
                
                
                202
                
                
                317Totalother assets
                
                
                13,567
                
                
                10,890Totalassets
                
                $
                148,524
                
                $
                150,050
  The
          accompanying notes are an integral part of the consolidated financial
          statements.
 
 F-4
  **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 **AND
          SUBSIDIARIES**
  **CONSOLIDATED
          BALANCE SHEETS**
 **U.S.
          dollars in thousands, except share and per share data**
  **December
                    31,****2006**
                
                **2007**LIABILITIES
                    AND SHAREHOLDERS' EQUITYCURRENT
                    LIABILITIES:Trade
                    payables
                
                $
                5,794
                
                $
                8,236Deferred
                    revenues
                
                
                5,399
                
                
                6,635Accrued
                    expenses and other accounts payable (Note 10)
                
                
                8,618
                
                
                8,583Totalcurrent liabilities
                
                
                19,811
                
                
                23,454ACCRUED
                    SEVERANCE PAY
                
                
                3,921
                
                
                4,802OTHER
                    LONG TERM LIABILITIES (Note 11)
                
                
                2,143
                
                
                2,564COMMITMENTS
                    AND CONTINGENT LIABILITIES (Note 12)SHAREHOLDERS'
                    EQUITY (Note 14):Share
                    capital: Ordinary shares of NIS 0.01 par value - Authorized:
                    20,000,000
                    shares at December 31, 2006 and 2007; Issued: 14,683,488 and
                    14,786,187
                    shares at December 31, 2006 and 2007, respectively, and outstanding:
                    14,683,488 and 13,857,490 shares at December 31, 2006 and 2007,
                    respectively
                
                
                44
                
                
                44Additional
                    paid-in capital
                
                
                82,439
                
                
                84,039Treasury
                    shares, at cost - 928,697 Ordinary shares as of December 31,
                    2007
                
                
                -
                
                
                (19,986
                )Accumulated
                    other comprehensive loss, net of tax
                
                
                (3,178
                )
                
                (2,917
                )Retained
                    earnings
                
                
                43,344
                
                
                58,050Totalshareholders' equity
                
                
                122,649
                
                
                119,230Totalliabilities and shareholders' equity
                
                $
                148,524
                
                $
                150,050
  The
          accompanying notes are an integral part of the consolidated financial
          statements.
 
 F-5
  **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 **AND
          SUBSIDIARIES**
  **CONSOLIDATED
          STATEMENTS OF INCOME**
 **U.S.
          dollars in thousands, except share and per share data**
  **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Revenues
                    (Note 15):Software
                    security
                
                $
                56,578
                
                $
                60,556
                
                $
                66,097Enterprise
                    security
                
                
                25,195
                
                
                28,482
                
                
                37,785Revenues
                    related to educational products (Note 8)
                
                
                -
                
                
                -
                
                
                2,000Totalrevenues
                
                
                81,773
                
                
                89,038
                
                
                105,882Cost
                    of revenues:Software
                    security
                
                
                9,870
                
                
                9,292
                
                
                11,745Enterprise
                    security
                
                
                7,101
                
                
                10,721
                
                
                13,077Cost
                    related to educational products (Note 8)
                
                
                -
                
                
                -
                
                
                2,508Totalcost of revenues
                
                
                16,971
                
                
                20,013
                
                
                27,330Gross
                    profit
                
                
                64,802
                
                
                69,025
                
                
                78,552Operating
                    expenses:Research
                    and development
                
                
                12,131
                
                
                14,336
                
                
                18,384Selling
                    and marketing
                
                
                26,952
                
                
                28,703
                
                
                33,194General
                    and administrative
                
                
                11,169
                
                
                12,780
                
                
                13,063Settlement
                    charge (Note 12b)
                
                
                2,000
                
                
                -
                
                
                -Totaloperating expenses
                
                
                52,252
                
                
                55,819
                
                
                64,641Operating
                    income
                
                
                12,550
                
                
                13,206
                
                
                13,911Financial
                    income, net (Note 16a)
                
                
                1,038
                
                
                3,240
                
                
                4,274Other
                    income, net
                
                
                14
                
                
                284
                
                
                14Income
                    before taxes on income
                
                
                13,602
                
                
                16,730
                
                
                18,199Taxes
                    on income (Note 13)
                
                
                1,246
                
                
                2,699
                
                
                2,768Income
                    before equity in loss of an affiliate
                
                
                12,356
                
                
                14,031
                
                
                15,431Equity
                    in loss of an affiliate
                
                
                -
                
                
                -
                
                
                (543
                )Net
                    income
                
                $
                12,356
                
                $
                14,031
                
                $
                14,888Earnings
                    per share (Note 16c):Basic
                
                $
                0.89
                
                $
                0.96
                
                $
                1.04Diluted
                
                $
                0.85
                
                $
                0.93
                
                $
                1.02Weighted
                    average number of shares used in computation of earnings per
                    share:Basic
                
                
                13,899,319
                
                
                14,596,119
                
                
                14,257,369Diluted
                
                
                14,580,328
                
                
                15,077,579
                
                
                14,663,133
  The
          accompanying notes are an integral part of the consolidated financial
          statements.
  F-6
 **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 **AND
          SUBSIDIARIES**
 **STATEMENTS
          OF CHANGES IN SHAREHOLDERS' EQUITY**
 **U.S.
          dollars in thousands, except share and per share data**
 **Accumulated****Additional**
                
                **Treasury**
                
                **Deferred**
                
                **other**
                
                
                
                **Total**
                
                **Total****Common
                    Stock**
                
                **paid-in**
                
                **shares**
                
                **Stock-based**
                
                **comprehensive**
                
                **Retained**
                
                **comprehensive**
                
                **shareholders'****Stock**
                
                **Amount**
                
                **capital**
                
                **At
                    cost**
                
                **compensation**
                
                **Income
                    (loss)**
                
                **earnings**
                
                **income**
                
                **equity**Balance
                    as of January 1, 2005
                
                
                12,345,536
                
                $
                39
                
                $
                39,696
                
                $
                -
                
                $
                (66
                )
                $
                (3,189
                )
                $
                16,957
                
                
                
                
                $
                53,437Issuance
                    of Ordinary shares, net
                
                
                2,000,000
                
                
                5
                
                
                38,773
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                
                
                
                38,778Exercise
                    of stock options
                
                
                139,527
                
                
                **)
                    -
                
                
                485
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                
                
                
                485Amortization
                    of deferred stock-based compensation
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                51
                
                
                -
                
                
                -
                
                
                
                
                
                51Comprehensive
                    income:Other
                    comprehensive gain (loss):Unrealized
                    loss on available-for-sale marketable securities, net of taxes
                    ($92)
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (302
                )
                
                -
                
                
                (302
                )
                
                (302
                )Foreign
                    currency translation adjustments
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (492
                )
                
                -
                
                
                (492
                )
                
                (492
                )Unrealized
                    gain from hedging transactions, net of taxes
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                424
                
                
                -
                
                
                424
                
                
                424Total
                    other comprehensive loss
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (370
                )
                
                -Net
                    income
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                12,356
                
                
                12,356
                
                
                12,356Total
                    comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                11,986Balance
                    as of December 31, 2005
                
                
                14,485,063
                
                
                44
                
                
                78,954
                
                
                -
                
                
                (15
                )
                
                (3,559
                )
                
                29,313
                
                
                -
                
                
                104,737Reclassification
                    of deferred compensation to additional paid-in capital due to
                    adoption of
                    SFAS 123(R)
                
                
                
                
                
                -
                
                
                (15
                )
                
                -
                
                
                15
                
                
                -
                
                
                -
                
                
                -
                
                
                -Stock-based
                    compensation expenses
                
                
                
                
                
                -
                
                
                2,268
                
                
                -
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                2,268Exercise
                    of stock options
                
                
                198,425
                
                
                **)
                    -
                
                
                835
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                835Deferred
                    tax due to issuance expenses from previous years
                
                
                
                
                
                -
                
                
                397
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                397Comprehensive
                    income:Other
                    comprehensive gain (loss):Unrealized
                    loss on available-for-sale marketable securities, net of taxes
                    ($163)
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (56
                )
                
                -
                
                
                (56
                )
                
                (56
                )Foreign
                    currency translation adjustments
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                441
                
                
                -
                
                
                441
                
                
                441Unrealized
                    loss from hedging transactions, net of taxes
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (4
                )
                
                -
                
                
                (4
                )
                
                (4
                )Total
                    other comprehensive income
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                381Net
                    income
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                14,031
                
                
                14,031
                
                
                14,031Total
                    comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                14,412Balance
                    as of December 31, 2006
                
                
                14,683,488
                
                
                44
                
                
                82,439
                
                
                -
                
                
                -
                
                
                *)
                    (3,178
                )
                
                43,344
                
                
                -
                
                
                122,649Cumulative
                    effect of changes in accounting for uncertainties in income taxes
                    (FIN
                    48)
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (182
                )
                
                -
                
                
                (182
                )Stock-based
                    compensation expenses
                
                
                
                
                
                -
                
                
                876
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                876Exercise
                    of stock options
                
                
                102,699
                
                
                **)
                    -
                
                
                724
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                724Purchase
                    of treasury shares at cost
                
                
                (928,697
                )
                
                -
                
                
                -
                
                
                (19,986
                )
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (19,986
                )Comprehensive
                    income:Other
                    comprehensive gain (loss):Unrealized
                    loss on available-for-sale marketable securities, net of taxes
                    ($7)
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (42
                )
                
                -
                
                
                (42
                )
                
                (42
                )Foreign
                    currency translation adjustments
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                318
                
                
                -
                
                
                318
                
                
                318Unrealized
                    loss from hedging transactions, net of taxes
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (15
                )
                
                -
                
                
                (15
                )
                
                (15
                )Total
                    other comprehensive income
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                261Net
                    income
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                14,888
                
                
                14,888
                
                
                14,888Total
                    comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                15,149Balance
                    as of December 31, 2007
                
                
                13,857,490
                
                $
                44
                
                $
                84,039
                
                $
                (19,986
                )
                $
                -
                
                $
                *)
                    (2,917
                )
                $
                58,050
                
                
                
                
                $
                119,230
 *)  Composed
          as follows:
 As
                    of December 31,2006
                
                2007Accumulated
                    unrealized gains from available-for-sale marketable securities,
                    net of
                    taxes ($0 and $7 as of December 31, 2006 and 2007, respectively)
                
                $
                58
                
                $
                16Accumulated
                    unrealized gains from hedging transactions, net of taxes
                
                
                15
                
                
                -Accumulated
                    foreign currency translation adjustments
                
                
                (3,251
                )
                
                (2,933
                )Accumulated
                    other comprehensive loss
                
                $
                (3,178
                )
                $
                (2,917
                )
 **)  Represents
          an amount lower than $ 1.
  The
          accompanying notes are an integral part of the consolidated financial
          statements.
 F-7
  **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 **AND
          SUBSIDIARIES**
  **CONSOLIDATED
          STATEMENTS OF CASH FLOWS**
 **U.S.
          dollars in thousands**
 
 **Years
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Cash
                    flows from operating activities:Net
                    income
                
                $
                12,356
                
                $
                14,031
                
                $
                14,888Adjustments
                    required to reconcile net income to net cash provided by operating
                    activities:Depreciation
                    and amortization
                
                
                1,967
                
                
                2,416
                
                
                2,797Cost
                    related to educational products
                
                
                -
                
                
                -
                
                
                2,508Gain
                    from sale of property and equipment
                
                
                (22
                )
                
                (60
                )
                
                (11
                )Accrued
                    interest on available-for-sale marketable debt securities
                
                
                (262
                )
                
                (240
                )
                
                110Gain
                    from marketable securities
                
                
                -
                
                
                (183
                )
                
                (679
                )Other-
                    than- temporary decline in fair value for available-for-sale
                    marketable
                    securities
                
                
                117
                
                
                -
                
                
                -Equity
                    in loss of an affiliate
                
                
                -
                
                
                -
                
                
                543Increase
                    (decrease) in accrued severance pay, net
                
                
                16
                
                
                (20
                )
                
                181Stock-based
                    compensation expenses
                
                
                51
                
                
                2,268
                
                
                876Deferred
                    income taxes, net
                
                
                (803
                )
                
                (354
                )
                
                (71
                )Increase
                    in trade receivables
                
                
                (1,619
                )
                
                (2,224
                )
                
                (39
                )Increase
                    in inventories
                
                
                (1,277
                )
                
                (97
                )
                
                (1,167
                )Increase
                    in other accounts receivable and prepaid expenses
                
                
                (189
                )
                
                (700
                )
                
                (1,221
                )Increase
                    in trade payables
                
                
                936
                
                
                1,321
                
                
                2,416Increase
                    in deferred revenues
                
                
                852
                
                
                528
                
                
                1,727Increase
                    (decrease) in other long term liabilities
                
                
                -
                
                
                1,369
                
                
                (373
                )Increase
                    (decrease) in accrued expenses and other accounts payable
                
                
                2,502
                
                
                840
                
                
                (344
                )Net
                    cash provided by operating activities
                
                
                14,625
                
                
                18,895
                
                
                22,141Cash
                    flows from investing activities:Investment
                    in available-for-sale marketable securities
                
                
                (40,465
                )
                
                (6,500
                )
                
                (43,265
                )Proceeds
                    from sales of available-for-sale marketable securities
                
                
                -
                
                
                4,371
                
                
                81,819Investment
                    in other assets
                
                
                -
                
                
                (2,508
                )
                
                -Purchase
                    of property and equipment
                
                
                (2,303
                )
                
                (4,576
                )
                
                (3,271
                )Proceeds
                    from sale of property and equipment
                
                
                34
                
                
                95
                
                
                11Investment
                    in other companies
                
                
                (850
                )
                
                (1,100
                )
                
                (495
                )Proceeds
                    from return on investment of other companies
                
                
                910
                
                
                1,736
                
                
                -Net
                    cash provided by (used in) investing activities
                
                
                (42,674
                )
                
                (8,482
                )
                
                34,799
  The
          accompanying notes are an integral part of the consolidated financial
          statements.
  F-8
  **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 **AND
          SUBSIDIARIES**
  **CONSOLIDATED
          STATEMENTS OF CASH FLOWS**
 **U.S.
          dollars in thousands**
  **Years
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Cash
                    flows from financing activities:Proceeds
                    from issuance of shares, net
                
                $
                38,778
                
                $
                -
                
                $
                -Purchase
                    of treasury shares
                
                
                -
                
                
                -
                
                
                (19,986
                )Proceeds
                    from exercise of options
                
                
                485
                
                
                835
                
                
                724Net
                    cash provided by (used in) financing activities
                
                
                39,263
                
                
                835
                
                
                (19,262
                )Effect
                    of exchange rate changes on cash and cash equivalents
                
                
                (101
                )
                
                60
                
                
                (203
                )Increase
                    in cash and cash equivalents
                
                
                11,113
                
                
                11,308
                
                
                37,475Cash
                    and cash equivalents at the beginning of the year
                
                
                17,313
                
                
                28,426
                
                
                39,734Cash
                    and cash equivalents at the end of the year
                
                $
                28,426
                
                $
                39,734
                
                $
                77,209Supplemental
                    disclosure:Cash
                    paid during the year for:Income
                    taxes
                
                $
                1,058
                
                $
                2,009
                
                $
                3,419
  The
          accompanying notes are an integral part of the consolidated financial
          statements.
 
 F-9
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            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
                    Ordinary shares of the Company are quoted on the Nasdaq Global
                    Market
                    ("Nasdaq") under the symbol ALDN. Since July 28, 2004, the shares are
                    also quoted on the Tel Aviv Stock Exchange. 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 SRM, a software marketing,
          licensing and distribution platform.
 
 Within
          the enterprise security segment, Aladdin develops and markets its patented
          USB-based eToken hardware and software 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 is 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.
  **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.
 
 F-10
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 **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 two foreign subsidiaries, whose functional
                    currency is not the U.S. dollar, have been translated into U.S.
                    dollars.
                    Effective April 1, 2007 one of the Company’s foreign subsidiaries changed
                    its functional currency from the US dollars to its local currency
                    as a
                    result of circumstances initiated by management that caused the
                    majority of its sales, expenses and cash flows to be denominated
                    in its
                    local currency. 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
                    prevailing during each 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 original maturities of three months or less at
          the date
          acquired.
  F-11
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            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 2007, 2006 and 2005, 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.
 
 The
          Company applies the guidance in FASB Staff Position (“FSP”) No. 115-1, “The
          Meaning of Other-Than-Temporary Impairment and Its Application to Certain
          Investment” (“FSP 115-1”) for determining when an investment is considered
          impaired, whether impairment is other-than temporary, and measurement of
          an
          impairment loss. An investment is considered impaired if the fair value
          of the
          investment is less than its cost. If, after consideration of all available
          evidence to evaluate the realizable value of its investment, impairment
          is
          determined to be other than- temporary, then an impairment loss should
          be
          recognized equal to the difference between the investment’s cost and its fair
          value.
  **Investment
          in other companies:**
 
 The
          investment in companies, in which the Company holds 20% or more (which
          are not
          subsidiaries), is accounted using the equity method.
 
 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
          Company's Investment in IDesia Ltd. ("IDesia") in which the Company holds
          16.58%
          as of December 31, 2007 is accounted for under the cost method. The Company
          accounted for periods in which it held more than 20%, under the cost method,
          after the Company considered the guidance provided within 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
          is in
          IDesia's Preferred Shares which is not in-substance common stock, the equity
          method should not be applied (see Note 6b).
 
 The
          Company's investment in Athena Smartcard Solution Ltd. ("Athena") in which
          the
          Company holds 28% as of December 31, 2007 is accounted for under the equity
          method (see Note 6c). The profits on inter-affiliate sales, not realized
          outside
          the group, were eliminated.
  F-12
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            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'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") and EITF 03-1, ”The meaning of other-than-temporary
          impairment and its application to certain investments.”(EITF 03-1”). As of
          December 31, 2007, 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 excess and slow-moving items, technological
          obsolescence and for market prices lower than cost.
 
 Cost
          is
          determined for all types of inventory using the moving average cost
          method.
 
 **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
                
                33Office
                    furniture and equipment
                
                7
                    -
                    10 (mainly 7%)Motor
                    vehicles
                
                15Leasehold
                    improvements
                
                Over
                    the shorter of the term of the lease or useful life
 
 **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 lives:
  **Years**Customer
                    list
                
                
                7Domain
                    name
                
                
                3Patent
                
                
                13.5
  F-13
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              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. Under the second step
          goodwill is reduced to its implied fair value through an adjustment to
          the
          goodwill balance, resulting in an impairment charge. The Company has elected
          to
          perform its analysis of goodwill during the fourth quarter of the year.
          During
          2005, 2006 and 2007, no impairment losses were identified.
 
 **Impairment
          of long-lived assets:**
 
 The
          long-lived assets of the Company and its subsidiaries and all identifiable
          intangible assets that are subject to amortization 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 2005, 2006 and 2007, 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
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 In
          June
          2006, the Financial Accounting Standards Board (FASB) issued Interpretation
          No.
          48 (“FIN 48”), Accounting for Uncertainty in Income Taxes—An interpretation of
          FASB Statement No. 109.
 The
          Interpretation clarifies the accounting for uncertainties in income taxes
          recognized in an enterprise’s financial statements and prescribes a recognition
          threshold and measurement attributes of income tax positions taken or expected
          to be taken on a tax return. Under FIN 48, the impact of an uncertain tax
          position taken or expected to be taken on an income tax return must be
          recognized in the financial statements at the largest amount that is
          more-likely-than-not to be sustained upon audit by the relevant taxing
          authority. An uncertain income tax position will not be recognized in the
          financial statements unless it is more likely than not of being sustained.
          The
          Company adopted the provisions of FIN 48 as of January 1, 2007. The impact
          of
          adopting FIN 48 was insignificant to the Company's consolidated financial
          statements in the total amount of $ 182.
 
 Interest
          associated with uncertain income tax positions and penalties are classified
          as
          income tax expenses. The Company has not recorded any material interest
          or
          penalties during any of the years presented.
 
 **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 from licensing the right to use its software products (eSafe, eToken,
          HASP
          SRM 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
          eToken is a hardware and software based product which contains a software
          content that is more than incidental to the product as a whole, since the
          Company's marketing efforts focus on the software solution, the maintenance
          and
          support post contract services are provided on the software component and
          most
          of the R&D expenses related to the product are in relation to the software
          component.
 
 F-15
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 The
          eSafe
          products are mainly software products, including perpetual, time-based
          licenses
          and maintenance and support post contract services. Accordingly, the Company
          accounts for its eToken and eSafe sales in accordance with SOP
          97-2.
 
 The
          Company generates revenues from sale of 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.
 
 *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, i.e., 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* .
          Payments that 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 concessions. 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 at the outset of the
          arrangement that collectibility is not probable based upon its review process,
          revenue is recognized as payments are received.
  F-16
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share data**
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 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 are 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 including maintenance and on-going support are recognized over
          the term
          of the agreement. 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 term of each arrangement.
 
 Deferred
          revenues include unearned amounts received from maintenance and support
          contracts as well as time-based licenses.
  F-17
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 **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
          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 net of fund’s profit for the years ended December 31, 2005, 2006
          and 2007 amounted to $ 1,336, $ 1,206 and $ 1,621,
          respectively.
 
 **Advertising
          expenses:**
 
 Advertising
          expenses are charged to the statement of operations, as incurred. Advertising
          expenses for the years ended December 31, 2005, 2006 and 2007 were $ 4,504,
          $ 4,208 and $ 4,162 respectively.
 
 F-18
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
          dollars in thousands, except share and per share data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
  **Basic
          and diluted earnings per share:**
 
 Basic
          earnings per share are computed based on the weighted average number of
          Ordinary
          shares outstanding during each year. Diluted 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 Standards No.
          128,
          "Earnings per Share" ("SFAS No. 128").
 
 The
          total
          weighted average number of outstanding options excluded from the calculations
          of
          diluted earnings per share was 90,925, 182,670 and 300,725 for the years
          ended
          December 31, 2005, 2006 and 2007, respectively, due to their anti-dilutive
          effect.
 
 **Accounting
          for stock-based compensation:**
 
 On
          January 1, 2006, the Company adopted Statement of Financial Accounting
          Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123(R)")
          which requires the measurement and recognition of compensation expense
          based on
          estimated fair values for all share-based payment awards made to employees
          and
          directors. SFAS 123(R) supersedes Accounting Principles Board Opinion
          No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), under which
          the Company previously accounted for its share based awards granted to
          employees
          and directors, for periods beginning in fiscal 2006. In March 2005, the
          Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
          ("SAB 107") relating to SFAS 123(R). The Company has applied the provisions
          of
          SAB 107 in its adoption of SFAS 123(R).
  F-19
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
          dollars in thousands, except share and per share data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 SFAS
          123(R) requires companies to estimate the fair value of equity-based payment
          awards on the date of grant using an option-pricing model. The value of
          the
          portion of the award that is ultimately expected to vest is recognized
          as an
          expense over the requisite service periods in the Company's consolidated
          income
          statement. Prior to the adoption of SFAS 123(R), the Company accounted
          for
          equity-based awards to employees and directors using the intrinsic value
          method
          in accordance with APB 25 as allowed under Statement of Financial Accounting
          Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123").
 
 The
          Company adopted SFAS 123(R) using the modified prospective transition method,
          which requires the application of the accounting standard starting from
          January 1, 2006, the first day of the Company's fiscal year 2006. Under
          that transition method, compensation costs recognized in 2006 and 2007,
          include:
          (a) compensation cost for all share-based payments granted prior to, but
          not yet
          vested as of January 1, 2006, based on the grant date fair value estimated
          in
          accordance with the original provisions of SFAS 123, and (b) compensation
          cost
          for all share-based payments granted starting from January 1, 2006, based
          on the
          grant-date fair value estimated in accordance with the provisions of Statement
          123(R). Results for prior periods have not been restated.
 
 The
          Company recognizes compensation expenses for the value of its awards, which
          have
          graded vesting, based on the accelerated attribution method over the vesting
          period, net of estimated forfeitures. Estimated forfeitures are based on
          actual
          historical pre-vesting forfeitures.
 
 As
          a
          result of adopting SFAS 123(R) on January 1, 2006, the Company's income
          before
          income taxes for the year ended December 31, 2006 was $ 2,268, lower than
          if it
          had continued to account for stock-based compensation under APB 25. Basic
          and
          diluted net earnings per share for 2006, are both $ 0.15 per share lower,
          than if the Company had continued to account for share-based compensation
          under
          APB 25.
 
 Prior
          to
          January 1, 2006, the Company applied the intrinsic value method of accounting
          for stock options as prescribed by APB 25, whereby compensation expense
          is equal
          to the excess, if any, of the quoted market price of the stock over the
          exercise
          price at the grant date of the award.
 
 The
          Pro-forma table below illustrates the effect of the Company’s stock based
          compensation expense on net income and basic and diluted earnings per share
          for
          2005, had the Company applied the fair value recognition provisions of
          SFAS
          123.
  F-20
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            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 under SFAS No. 123:
  **Year
                    endedDecember 31,****2005**Net
                    income - as reported
                
                $
                12,356Add:
                    stock-based employee compensation intrinsic value
                
                
                51Deduct:
                    stock-based employee compensation - fair value
                
                
                1,659Pro
                    forma net income:
                
                $
                10,748Net
                    earnings per share:Basic
                    net earnings per Ordinary share, as reported
                
                $
                0.89Diluted
                    net earnings per Ordinary share, as reported
                
                $
                0.85Basic
                    pro forma net earnings per Ordinary share
                
                $
                0.77Diluted
                    pro forma net earnings per Ordinary share
                
                $
                0.74
 
 The
          fair
          value for options granted in 2005 is amortized over their vesting period
          and
          estimated at the date of grant using the Black-Scholes-Merton options pricing
          model with the following weighted average assumptions:
  **Year
                    endedDecember 31,****2005**Expected
                    dividend yield
                
                
                0
                %Expected
                    volatility
                
                
                78.9
                %Risk-free
                    interest rate
                
                
                3.9
                %Average
                    Expected life of up to
                
                
                6
                    years
 
 Pro-forma
          compensation expense under SFAS 123, among other computational differences,
          does
          not consider potential pre-vesting forfeitures. Because of these differences,
          the pro-forma stock based compensation expense presented above for the
          prior
          year ended December 31, 2005 under SFAS 123 and the stock based compensation
          expense recognized during the years ended December 31, 2007 and 2006 under
          SFAS 123(R) are not directly comparable.
  F-21
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              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 used the Black-Scholes-Merton option-pricing model in 2006 through
          June
          30, 2007 and the Monte-Carlo Simulation model thereafter, to estimate the
          fair
          value of options granted. The Monte-Carlo model considers characteristics of
          fair value option pricing that are not available under the Black-Scholes-Merton
          model. Similar to the Black-Scholes model, the Monte-Carlo model takes
          into
          account variables such as volatility, dividend yield rate, and risk free
          interest rate. However, in addition, the Monte-Carlo model considers the
          contractual term of the option, the probability that the option will be
          exercised prior to the end of its contractual life, and the probability
          of
          termination or retirement of the option holder in computing the value of
          the
          option. For these reasons, the Company believes that the Monte-Carlo model
          provides a fair value that is more representative of actual experience
          and
          future expected experience than that calculated using the Black-Scholes
          model.
 
 The
          impact on the basic and diluted net income per share for the six month
          period
          ended December 31, 2007 had the Company continued to account for share-based
          compensation using the Black-Scholes option pricing model is not
          significant.
 
 The
          Black-Scholes option-pricing model requires a number of assumptions, of
          which
          the most significant are expected stock price volatility and the expected
          option
          term. Expected volatility was calculated based upon actual historical stock
          price movements over the most recent periods ending June 30, 2007, equal
          to the
          expected option term. The expected option term represents the period that
          the
          Company's stock options are expected to be outstanding and was determined
          based
          on historical experience of similar options, giving consideration to the
          contractual terms of the stock options. The Company has historically not
          paid
          dividends and has no foreseeable plans to issue dividends. The risk-free
          interest rate is based on the yield from U.S. Treasury zero-coupon bonds
          with an
          equivalent term.
 The
          following weighted assumptions were used in the Black-Scholes option pricing
          model for 2006 and for the six months period ended June 30, 2007:
 
 **Year
                    ended**
                
                **Six
                    months****December
                    31,**
                
                **ended
                    June 30,****2006**
                
                **2007**Expected
                    dividend yield
                
                
                0
                %
                
                0
                %Expected
                    volatility
                
                
                67.3
                %
                
                59
                %Risk-free
                    interest rate
                
                
                4.6
                %
                
                4.8
                %Expected
                    option term
                
                
                4.5
                    years
                
                
                3.6
                    yearsForfeiture
                    rate
                
                
                10.5
                %
                
                16.7
                %
  The
                    Monte-Carlo Simulation for option pricing requires a number of
                    assumptions, of which the most significant are the suboptimal
                    exercise
                    factor and expected stock price volatility. The suboptimal exercise
                    factor
                    is estimated using historical option exercise information. The
                    suboptimal
                    exercise factor is the ratio by which the stock price must increase
                    over
                    the exercise price before employees are expected to exercise
                    their stock
                    options. The expected life of employee stock options is a derived
                    output
                    of this assumption from the Monte-Carlo Simulation.
 
 F-22
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 Expected
          volatility is based upon actual historical stock price movements over the
          most
          recent periods. Expected volatility is calculated as of the grant dates
          for
          different periods, since the Monte-Carlo Simulation is used for different
          expected volatilities for different periods.
 
 The
                    Company has historically not paid dividends and has no foreseeable
                    plans
                    to issue dividends. The risk-free interest rate is based on the
                    yield from
                    U.S. Treasury zero-coupon bonds with an equivalent term and calculated
                    for
                    different periods that are in line with the expected volatility
                    periods.
 
 The
          expected option term represents the period that the Company's stock options
          are
          expected to be outstanding and was determined based on historical experience
          of
          similar options, giving consideration to the contractual terms of the stock
          options.
 
 The
          following weighted assumptions were used in the Monte-Carlo Simulation
          model for
          the six months period ended December 31, 2007:
 
 Expected
                    dividend yield
                
                
                0
                %Expected
                    volatility
                
                
                44
                %Risk-free
                    interest rate
                
                
                4.1
                %Expected
                    option term
                
                
                5.1
                    yearsForfeiture
                    rate
                
                
                16.7
                %Contractual
                    term of up to
                
                
                10
                    yearsSuboptimal
                    exercise multiple
                
                
                2
 
 During
          2006 and 2007, the Company recognized stock-based compensation expense
          related
          to employee stock options in the amount of $ 2,268 and 876 respectively as
          follows:
 
 **Year
                    ended December 31,****2006**
                
                **2007**Cost
                    of revenue
                
                $
                43
                
                $
                -Research
                    and development
                
                
                666
                
                
                420Selling
                    and marketing
                
                
                732
                
                
                452General
                    and administrative
                
                
                827
                
                
                4Total
                    Stock-based compensation expense
                
                $
                2,268
                
                $
                876
 
 During
          the year ended December 31 2005, the Company recognized general and
          administrative, stock-based compensation expense in the amount of $ 51.
  F-23
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 **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.
 
 The
          Company's marketable securities as of December 31, 2007 include investments
          in
          Corporate and U.S. Government Bonds. Management believes that minimal credit
          risk exists with respect to these marketable securities.
 
 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, 2005, 2006
          and 2007
          were $ 114, $ 208 and $ 128, respectively.
 
 **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 of
          repurchased Treasury shares as a reduction of shareholders' equity.
 
 F-24
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 **Derivative
          instruments:**
 
 The
          Company has instituted a foreign currency fair value and cash flow hedging
          program using forward contracts and purchased put and call options to hedge
          against the risk of overall changes in the fair value of its trade payables
          and
          receivables due to foreign exchange rates and in cash flows resulting from
          forecasted foreign currency sales and operating expenses for a period of
          up to
          one 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,
          the 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.
 
 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 recognized in the statements of income and included in the financial
          expenses.
 
 The
          Company recognized net gains from derivative instruments of $ 324, $ 12
          and $
          277 during the years ended December 31, 2005, 2006 and 2007, respectively.
          The amounts of $ 132 and $ 23, were offset against the revenues in the
          statement of income during the years ended December 31, 2005 and 2006,
          respectively, an amount of $ 92 was offset against operating expenses during
          the
          year ended December 31, 2007, and amounts of $ 456, $ 35 and $ 185 were
          included
          in financial income, net, during the years ended December 31, 2005, 2006
          and
          2007, respectively.
 
 F-25
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 **Impact
          of recently issued accounting standards:**
 
 In
          September 2006, the FASB issued Statement of Financial Accounting Standards
          No.
          157, “Fair Value Measurements” (SFAS 157) which defines fair value, establishes
          a framework for measuring fair value, and expands disclosures about fair
          value
          measurements. SFAS 157 applies to other accounting pronouncements that
          require
          or permit fair value measurements and, accordingly, does not require any
          new
          fair value measurements. SFAS 157 is effective for fiscal years beginning
          after
          November 15, 2007 for financial assets and liabilities, as well as for
          any other
          assets and liabilities that are carried at fair value on a recurring basis,
          and
          should be applied prospectively. The adoption of the provisions of SFAS
          157
          related to financial assets and liabilities and other assets and liabilities
          that are carried at fair value on a recurring basis is not anticipated
          to
          materially impact the Company’s consolidated financial position and results of
          operations. Subsequently, the FASB provided for a one-year deferral of
          the
          provisions of SFAS 157 for non-financial assets and liabilities that are
          recognized or disclosed at fair value in the consolidated financial statements
          on a non-recurring basis. The Company is currently evaluating the impact
          of
          adopting the provisions of SFAS 157 for non-financial assets and liabilities
          that are recognized or disclosed on a non-recurring basis.
 
 In
          February 2007, the FASB issued Statement of Financial Accounting Standards
          No.
          159, “The Fair Value Option for Financial Assets and Financial Liabilities”
(SFAS 159). Under this Standard, the Company may elect to report financial
          instruments and certain other items at fair value on a contract-by-contract
          basis with changes in value reported in earnings. This election is irrevocable.
          SFAS 159 provides an opportunity to mitigate volatility in reported earnings
          that is caused by measuring hedged assets and liabilities that were previously
          required to use a different accounting method than the related hedging
          contracts
          when the complex provisions of SFAS 133 hedge accounting are not met. SFAS
          159
          is effective for years beginning after November 15, 2007.  The Company does
          not expect the adoption of SFAS 159 will have a material impact on its
          consolidated financial statements.
 
 In
          December 2007, the FASB issued Statement of Financial Accounting Standards
          No.
          141 (Revised 2007) (SFAS 141R), Business Combinations. SFAS 141R will change
          the
          accounting for business combinations. Under SFAS 141R, an acquiring entity
          will
          be required to recognize all the assets acquired and liabilities assumed
          in a
          transaction at the acquisition-date fair value with limited exceptions.
          SFAS
          141R will change the accounting treatment and disclosure for certain specific
          items in a business combination. SFAS 141R applies prospectively to business combinations
          for which the acquisition date is on or after the beginning of the first
          annual
          reporting period beginning on or after December 15, 2008. SFAS 141R will
          have an
          impact on accounting for future business combinations once adopted and
          not on
          prior acquisitions.
 
 F-26
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
  **NOTE
                    2:-**
                **SIGNIFICANT
                    ACCOUNTING POLICIES
                    (Cont.)**
 
 In
          December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
          Consolidated Financial Statements” (“SFAS 160”). SFAS 160 establishes accounting
          and reporting standards for ownership interests in subsidiaries held by
          parties
          other than the parent, the amount of consolidated net income attributable
          to the
          parent and to the noncontrolling interest, changes in a parent’s ownership
          interest and the valuation of retained noncontrolling equity investments
          when a
          subsidiary is deconsolidated. SFAS 160 also establishes reporting requirements
          that provide sufficient disclosures that clearly identify and distinguish
          between the interests of the parent and the interests of the noncontrolling
          owners. This standard is effective for fiscal years beginning after December
          15,
          2008  and
          should be applied prospectively. However, the presentation and disclosure
          requirements of the statement shall be applied retrospectively for all
          periods
          presented. The adoption of the provisions of Statement No. 160 is not
          anticipated to materially impact the Company’s consolidated financial position
          and results of operations.
 
 **Reclassification:**
 
 Certain
          prior period amounts have been reclassified to conform to the current period
          presentation.
  F-27
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              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, 2007****Estimated****Gross**
                
                **Gross**
                
                **fair****unrealized**
                
                **unrealized**
                
                **market****Cost**
                
                **gains**
                
                **losses**
                
                **value**Bonds
                    with contractual maturities ofless
                    than 1 year
                
                $
                10,124
                
                $
                25
                
                $
                -
                
                $
                10,149Bonds
                    with contractual maturities ofmore
                    than 1 year
                
                
                2,980
                
                
                2
                
                
                4
                
                
                2,978$
                13,104
                
                $
                27
                
                $
                4
                
                $
                13,127
  **December
                    31, 2006****Estimated****Gross**
                
                **Gross**
                
                **fair****unrealized**
                
                **unrealized**
                
                **market****Cost**
                
                **gains**
                
                **losses**
                
                **value**Government
                    bonds with contractual maturities of less than 1 year
                
                $
                24,089
                
                $
                80
                
                $
                22
                
                $
                24,147Auction
                    rate securities
                
                
                27,000
                
                
                -
                
                
                -
                
                
                27,000$
                51,089
                
                $
                80
                
                $
                22
                
                $
                51,147
 
 No
          losses
          are outstanding over a twelve month period since all the outstanding securities
          were purchased during 2007. Because these unrealized losses are deemed
          to be due
          to temporary changes in interest rates and not in issuers’ liquidity, the
          securities were not considered to be other than temporarily impaired at
          December
          31, 2007 and 2006.
 
 **NOTE
                    4:-**
                **OTHER
                    ACCOUNTS RECEIVABLE AND PREPAID
                    EXPENSES**
 
 **December
                    31,****2006**
                
                **2007**Loans
                    to employees
                
                $
                376
                
                $
                409Prepaid
                    expenses
                
                
                2,361
                
                
                2,147Government
                    authorities
                
                
                1,074
                
                
                980Advances
                    to suppliers
                
                
                200
                
                
                907Related
                    party (See Note 6c)
                
                
                21
                
                
                750Other
                
                
                171
                
                
                221$
                4,203
                
                $
                5,414
 
 F-28
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
                    5:-**
                **INVENTORIES**
 **December
                    31,****2006**
                
                **2007**Raw
                    materials, parts and supplies
                
                $
                3,169
                
                $
                3,624Work-in-progress
                
                
                1,253
                
                
                1,023Finished
                    products
                
                
                2,877
                
                
                4,116$
                7,299
                
                $
                8,763
 
 A
          write-off in the amount of $ 422, $ 336 and $ 496 was recognized in the
          years
          ended December 31, 2005, 2006 and 2007 respectively.
 
 **NOTE
                    6:-**
                **INVESTMENT
                    IN OTHER COMPANIES**
 
 **December
                    31,****2006**
                
                **2007**Investment
                    in Tamir Fishman Ventures II, LLC (see a below)
                
                $
                *)
                    4,423
                
                $
                -Investment
                    in IDesia.Ltd. (see b below)
                
                
                1,100
                
                
                1,100Investment
                    in Athena Smartcard solutions Ltd. (see c below)
                
                
                250
                
                
                **)
                    205$
                5,773
                
                $
                1,305
 
 *)  Net
          of
          impairment in the amount of $1,039
  **)
          Net
          of equity in loss of $543
 
 a.
                Investment
                    in Tamir Fishman Ventures II, LLC
 
 Through
          December 31, 2007, the Company had invested an aggregate amount of $ 8,097
          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.
 
 During
          2005, 2006 and 2007, based on management's most recent analysis, no additional
          impairment losses have been identified.
 
 In
          2005
          and 2006, as a result of exit transactions for portfolio companies of Tamir
          Fishman, the Company received distributions of $ 910 and $ 1,736 in cash.
          Distributions received in 2005 and 2006 were recorded as a return of investment.
          No distribution was received in 2007.
 
 F-29
  **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 **AND
          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
          February 2008, the Company sold approximately 52% of the investment. The
          consideration was $ 2,904 and the net gain was $ 614. The Company expects
          to
          sell the remainder of this investment during 2008.
 
 b.
                Investment
                    in IDesia Ltd..
 
 In
          April
          2004, the Company entered into a convertible loan agreement with IDesia
          Ltd.
          ("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) which were converted into Series A preferred shares of IDesia upon
          the achievement of certain agreed upon milestones. 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.
 
 During
          the first quarter of 2007 IDesia completed an additional investment round
          in
          which the Company did not participate, and therefore as of December 31,
          2007,
          the Company owned 16.58% of the share capital of IDesia. No indications
          of
          impairment were identified.
 
 The
          investment is stated at cost, since the investment is in preferred shares
          that
          are not in-substance common stock (see Note 2).
  F-30
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
          6:-**  **INVESTMENT
          IN OTHER COMPANIES (Cont.)**
 
 c.
                Investment
                    in Athena Smartcard Solutions Ltd.
 
 In
          November 2006 the Company  entered
          into an agreement with K.K. Athena Smartcard Solutions Ltd., a Japanese
          company
          ("Athena"), whereby the Company was granted an option allowing it to invest
          up
          to $745 in Athena at any time until June 30, 2007, in consideration for
          the
          issuance of shares of Athena. The option is exercisable in three instalments
          of
          $248 each. Each installment represents 2.3% of Athena's fully diluted share
          capital. The Company has completed the three installments during 2007,
          increasing its holdings in Athena's share capital from 23.5% as of December
          31,
          2006 to 28% as of December 31, 2007 (see also Notes 2 and 17).
  The
          Company has invested in Athena previously but Athena has incurred losses
          over
          the years and Aladdin has accordingly reduced its investments and loans
          in
          Athena to zero in 2004.The Company's investment in Athena was accounted
          for
          under the equity method
 
 In
          October 2006, the Company entered into License Agreement with Athena. Pursuant
          to this agreement Athena granted Aladdin a worldwide perpetual non revocable,
          transferable, non-exclusive license to use any intellectual property rights,
          including without limitation patents, trade secrets, trademarks and copyrights
          in the Licensed Software for the amount of $ 250. Aladdin can solely use
          the
          license and market, sublicense, distribute and sell it as embedded in or
          integrated with the Aladdin products. The Company recorded this amount
          in the
          prepaid expenses according to the relative fair value. (See also note
          16b)
 
 **NOTE
              7:-** **PROPERTY
              AND EQUIPMENT, NET**
   **December
                    31,****2006**
                
                **2007**Cost:Computers
                    and peripheral equipment
                
                $
                14,927
                
                $
                8,813Office
                    furniture and equipment
                
                
                2,363
                
                
                2,108Motor
                    vehicles
                
                
                301
                
                
                309Leasehold
                    improvements
                
                
                3,732
                
                
                2,78221,323
                
                
                14,012Accumulated
                    depreciation:Computers
                    and peripheral equipment
                
                
                12,463
                
                
                5,426Office
                    furniture and equipment
                
                
                1,576
                
                
                1,246Motor
                    vehicles
                
                
                174
                
                
                200Leasehold
                    improvements
                
                
                1,415
                
                
                63915,628
                
                
                7,511Depreciated
                    cost
                
                $
                5,695
                
                $
                6,501
 
 Depreciation
          expenses for the years ended December 31, 2005, 2006 and 2007 amounted
          to
          $ 1,409, $ 1,958 and $ 2,529, respectively.
  F-31
 
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
              dollars in thousands, except share and per share
              data**
 
 **NOTE
              8:-** **INTANGIBLE
              ASSETS, NET**
 
 a.
                    The
                        following table does not include fully amortized, in all
                        presented years,
                        intangible assets:
 
 **December
                    31,****2006**
                
                **2007**Subject
                    to amortizationCost:Customer
                    list (1)
                
                $
                1,151
                
                $
                1,151Domain
                    name (2)
                
                
                430
                
                
                430Patent
                    (3)
                
                
                550
                
                
                550Educational
                    products (4)
                
                
                2,508
                
                
                2,5084,639
                
                
                4,639Accumulated
                    amortization:Customer
                    list (1)
                
                
                410
                
                
                565Domain
                    names (2)
                
                
                358
                
                
                430Patent
                    (3)
                
                
                326
                
                
                367Educational
                    products (4)
                
                
                -
                
                
                2,5081,094
                
                
                3,870Amortized
                    cost
                
                
                3,545
                
                
                769Not
                    subject to amortizationCost:Domain
                    name (5)
                
                
                500
                
                
                500Intangible
                    assets, net
                
                $
                4,045
                
                $
                1,269
  (1)
                Customer
                    list - is being amortized over a period of seven years and will
                    be fully
                    amortized in 2011.
 
 (2)
                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 was amortized over a period
                    of 3 years
                    (fully amortized in 2007).
 
 F-32
 
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
              8:-** **INTANGIBLE
              ASSETS, NET (Cont.)**
 
 (3)
                Patent
                    - is being amortized over its useful life and will be fully amortized
                    in
                    2012.
 
 (4)
                As
                    of December 31, 2006 the Company has accumulated a total amount
                    of
                    approximately $ 2,508 in direct expenses for developing and producing
                    video based training (“VBT”) materials in regards to certain tender. The
                    up-front non recurring cost was fully expensed during 2007 in
                    connection
                    with a perpetual license agreement signed by the Company. According
                    to the
                    agreement, the right to use and distribute the VBT DVD's was
                    sold in
                    consideration for one time license. The amount was recorded as
                    non
                    recurring expense as part of cost of
                    revenue.
  (5)
                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 is being reviewed annually for impairment.
 
 b.
                  Amortization
                      expenses for the years ended December 31, 2005, 2006 and 2007,
                      amounted to
                      $ 558, $ 458 and $ 2,776,
                      respectively.
 
 c.
                  Estimated
                      amortization expenses for the next five
                      years:
 
 2008
                
                $
                2052009
                
                
                2052010
                
                
                2052011
                
                
                1352012
                
                
                19$
                769
 
 **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 carrying
          amount of goodwill as of December 31, 2006 and 2007 is as follows:
 
 **Software
                    Security (DRM)**
                  **segment**
                
                **Enterprise
                    Security segment**
                
                **Total**Balance
                    as of December 31, 2006 and 2007
                
                $
                6,845
                
                $
                840
                
                $
                7,685
 
 Goodwill
          acquired was allocated to reporting units based on the expected benefits
          of the
          business acquired to each reporting unit.
  F-33
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
          10:-**  **ACCRUED
          EXPENSES AND OTHER ACCOUNTS PAYABLES**
 
 **December
                    31,****2006**
                
                **2007**Employees
                    and payroll accruals
                
                $
                4,434
                
                $
                4,739Income
                    taxes payable
                
                
                2,535
                
                
                2,349Accrued
                    expenses and other *)
                
                
                1,649
                
                
                1,495$
                8,618
                
                $
                8,583
 
 *)
          Accrued expenses as of December 31, 2006 and 2007 include a sum of $373
          which
          reflects current portion of participation in leasehold improvement; **** the
          Company classified in 2006 and 2007 an amount of $1,369 and $996 as other
          long
          term liabilities.
 
 **NOTE
          11:-**  **OTHER
          LONG TERM LIABILITIES**
  **December
                    31,****2006**
                
                **2007**Deferred
                    revenues
                
                $
                774
                
                $
                1,568Participation
                    in leasehold improvements, net
                
                
                1,369
                
                
                996$
                2,143
                
                $
                2,564
 
 **NOTE
              12:-** **COMMITMENTS
              AND CONTINGENT LIABILITIES**
 
 a.
                    Lease
                        commitments:
  The
          Company’s 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, 2007,
          are as
          follows:
  **Facilities**
                
                **Motor
                    vehicles**
                
                **Total**Year
                    ended December, 312008
                
                $
                2,185
                
                $
                1,482
                
                $
                3,6672009
                
                
                2,088
                
                
                922
                
                
                3,0102010
                
                
                1,294
                
                
                328
                
                
                1,6222011
                
                
                707
                
                
                52
                
                
                7592012
                
                
                79
                
                
                -
                
                
                79$
                6,353
                
                $
                2,784
                
                $
                9,137
 
 Facilities
          lease expenses for the years ended December 31, 2005, 2006 and 2007 were
          approximately $ 1,785, $ 2,065 and $ 2,475, respectively.
 
 Motor
          vehicle lease expenses for the years ended December 31, 2005, 2006 and
          2007 were
          approximately $ 1,294, $ 1,535 and $ 1,777, respectively.
  F-34
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 **NOTE
              12:-** **COMMITMENTS
              AND CONTINGENT LIABILITIES (Cont.)**
 
 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 $8,525 on demand from
          Tamir
          Fishman, out of which, as of December 31, 2007, the Company had already
          invested
          $ 8,097.
  In
          February 2008, the Company sold approximately 52% of the investment thus
          reducing the commitment accordingly to $208.
  F-35
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
              13:-** **TAXES
              ON INCOME**
 
 a.
                  Israeli
                      corporate tax structure:
 
 Generally,
          Israeli companies are subject to “Corporate Tax” on their taxable income at the
          rate of 29% for the 2007 tax year. Following an amendment to the Israeli
          Income
          Tax Ordinance [New Version], 1961 (the “Israeli Tax Ordinance”), which came into
          effect on January 1,2006, the corporate tax rate is scheduled to decrease
          as
          follows: 27% for the 2008 tax year, 26% for the 2009 tax year and 25% for
          the
          2010 tax year and thereafter. Israeli companies are generally subject to
          capital
          gains tax at a rate of 25% for capital gains (other than gains deriving
          from the
          sale of listed securities) derived after January 1, 2003.
 
 b.
                    Tax
                        benefits under the Law for the Encouragement of Capital Investments,
                        1959
                        ("the Law"):
 
 The
          Company's production facilities have been granted tax benefits under the
          law,
          under eight separate investment programs, out of which six are "Approved
          Enterprise" and two are “ Privileged
          Enterprise” under the amendment further discussed below .
          Pursuant to the Law, the Company has elected the "alternative benefits"
          track
          and has waived Government grants in return for a tax exemption. The
          main
          benefit arising from such status is the reduction in tax rates on income
          derived
          from "Approved Enterprises". Consequently, the Company is entitled to a
          two-year
          tax exemption and five to eight years of tax at a reduced rate of 10%-25%,
          based
          on the percentage of foreign investment in the Company.
 
 By
          virtue
          of this law, the Company is entitled to claim accelerated depreciation
          on
          equipment used by the "Approved Enterprise" during five tax years.
 
 For
          the
          Company's eight 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.
 
 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 main benefit is that the Company is tax-exempt
          for a
          benefit period of 10 years. The
          period of benefits relating to all investment programs will expire in the
          years
          2009 through 2016.
 
 The
          allocation of the income tax between the priority regions is calculated
          by a
          formula that was authorized by Israel Tax Authority.
  F-36
  **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share data**
 **NOTE
                  13:-** **TAXES
                  ON INCOME (Cont.)**
 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.
 
 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, 2007, retained earnings included approximately $ 44,613 in
          tax-exempt profits earned by the Company's "Approved and Privileged
          Enterprises". 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 and an income tax liability of up to approximately
          $
          6,692 would be incurred as of December 31, 2007.
 
 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, 2007, the Company met all of the aforementioned
          conditions **.**
 
 Income
          from sources other than the "Approved and privileged 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 29% (see also Note 13a)
          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.
  F-37
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
              dollars in thousands, except share and per share
              data**
  **NOTE
              13:-** **TAXES
              ON INCOME (Cont.)**
 c.
                    Measurement
                        of taxable income under the Income Tax (Inflationary Adjustments)
                        Law,
                        1985:
  Until
          the
          year 2005, 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.
 
 d.
                    Measurement
                        of taxable income:
 
 Commencing
          in taxable year 2006, the Company has elected to measure its taxable income
          and
          file its tax return under the Israeli Income Tax Regulations (Principles
          Regarding the Management of Books of Account of Foreign Invested Companies
          and
          Certain Partnerships and the Determination of Their Taxable Income), 1986.
          Accordingly, commencing taxable year 2006, results for tax purposes are
          measured
          in terms of earnings in U.S. dollar.
 
 e.
                    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.
 
 f.
                    Income
                        before taxes is comprised as
                        follows:
  **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Domestic
                
                $
                8,809
                
                $
                13,583
                
                $
                14,422Foreign
                
                
                4,793
                
                
                3,147
                
                
                3,777$
                13,602
                
                $
                16,730
                
                $
                18,199
  g.
                      The
                          income tax provision (benefit) for the years ended December
                          31, 2005, 2006
                          and 2007 consisted of the
                          following:
  Current
                  
                  $
                  1,785
                  
                  $
                  3,062
                  
                  $
                  2,837Taxes
                      in respect of prior years
                  
                  
                  264
                  
                  
                  (9
                  )
                  
                  2Deferred
                  
                  
                  (803
                  )
                  
                  (354
                  )
                  
                  *)
                      (71
                  )$
                  1,246
                  
                  $
                  2,699
                  
                  $
                  2,768Domestic
                  
                  $
                  583
                  
                  $
                  2,933
                  
                  $
                  2,411Foreign
                  
                  
                  663
                  
                  
                  (234
                  )
                  
                  357$
                  1,246
                  
                  $
                  2,699
                  
                  $
                  2,768
  *)
            Including deferred tax expenses derived from issuance of shares in the
            amount of
            $ 199
  F-38
 
  **ALADDIN
                  KNOWLEDGE SYSTEMS LTD.**
 **AND
                  SUBSIDIARIES**
  **NOTES
                  TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
                  dollars in thousands, except share and per share
                  data**
 **NOTE
              13:-** **TAXES
              ON INCOME (Cont.)**
 
 h.
                    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,****2006**
                
                **2007**Deferred
                    tax assets:Reserves
                    and allowances
                
                $
                1,501
                
                $
                1,645AMT
                    credit carry forwards
                
                
                28
                
                
                42Net
                    operating loss carry forwards in subsidiaries
                
                
                8,924
                
                
                9,473Net
                    deferred tax assets before valuation allowance
                
                
                10,453
                
                
                11,160Valuation
                    allowance
                
                
                (7,292
                )
                
                (7,492
                )Total
                    deferred tax assets
                
                
                3,161
                
                
                3,668Deferred
                    tax liability:Deferred
                    tax liability from unrealized gain on available- for-sale
                    securities
                
                
                -
                
                
                (7
                )Reserves
                    and allowances
                
                
                -
                
                
                (395
                )Total
                    deferred tax liability
                
                
                -
                
                
                (402
                )Net
                    deferred tax assets
                
                $
                3,161
                
                $
                3,266
  Domestic:Current
                    deferred tax asset
                
                $
                1,013
                
                $
                909Current
                    deferred tax liability
                
                
                -
                
                
                (32
                )Non
                    current deferred tax asset
                
                
                476
                
                
                5211,489
                
                
                1,398Foreign:Current
                    deferred tax asset, net
                
                
                513
                
                
                770Non
                    current deferred tax asset
                
                
                1,159
                
                
                1,468Non
                    current deferred tax liability
                
                
                -
                
                
                (370
                )1,672
                
                
                1,868$
                3,161
                
                $
                3,266
  Current
            deferred tax liability and current deferred tax assets are included within
            total
            current assets in the balance sheets.
  Non
            current tax liability and non current deferred tax assets are included
            within
            other long term assets in the balance sheets.
 F-39
 **ALADDIN
                KNOWLEDGE SYSTEMS LTD.**
 **AND
                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 Kingdom and Germany have estimated
          total
          available carry-forward tax losses of $1,020
          and $
          9,207, respectively, to offset against future tax profits for an indefinite
          period.
  The
          Company's subsidiary in the Netherlands has
          estimated total available carry-forward tax losses as of December 31, 2007
          of
          $2,040
          to offset against future tax profits for period of 4 years.
 
 The
          Company's subsidiary in the United States has estimated total available
          carry-forward tax losses as of December 31, 2007 of $15,402
          to
          offset against future tax profits for periods of 15 to 20 years. 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.
 
 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 $ 7,292 and $ 7,492 at December 31, 2006 and 2007,
          respectively.
  F-40
  **ALADDIN
                KNOWLEDGE SYSTEMS LTD.**
 **AND
                SUBSIDIARIES**
  **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
                dollars in thousands, except share and per share
                data**
 
 **NOTE
              13:-** **TAXES
              ON INCOME (Cont.)**
 
 i.
                    A
                        reconciliation between the theoretical tax expense, assuming
                        all income is
                        taxed at the statutory tax rate applicable to income of the
                        Company in
                        Israel and the actual tax expense as reported in the statement
                        of income
                        is as follows:
 
 **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Income
                    before taxes, as reported in the consolidated statements of
                    income
                
                $
                13,602
                
                $
                16,730
                
                $
                18,199Statutory
                    tax rate
                
                
                34
                %
                
                31
                %
                
                29
                %Expense
                    computed at the statutory tax rate
                
                $
                4,625
                
                $
                5,186
                
                $
                5,278Decrease
                    in taxes resulting from "Approved Enterprise" and "Privileged
                    Enterprise"
                    benefits (1)
                
                
                (1,813
                )
                
                (1,774
                )
                
                (1,952
                )Tax
                    adjustment in respect of foreign subsidiary different tax rate
                
                
                17
                
                
                (10
                )
                
                187Change
                    in valuation allowance
                
                
                (77
                )
                
                (268
                )
                
                200Utilization
                    of loss carry-forward
                
                
                (1,261
                )
                
                (1,001
                )
                
                (771
                )Items
                    for which no deferred tax was recorded
                
                
                (918
                )
                
                (396
                )
                
                (22
                )Taxes
                    in respect of prior years
                
                
                264
                
                
                (9
                )
                
                3Stock
                    compensation relating to options per SFAS 123(R)- Non-deductible
                    expenses
                
                
                -
                
                
                695
                
                
                254Other
                    non-deductible expenses
                
                
                320
                
                
                501
                
                
                240Impact
                    of foreign currency translation adjustments
                
                
                92
                
                
                (250
                )
                
                (500
                )Other
                
                
                (3
                )
                
                25
                
                
                (149
                )Actual
                    tax expense
                
                $
                1,246
                
                $
                2,699
                
                $
                2,768(1)Per
                    share amounts (basic) of the tax benefit resulting from "Approved
                    Enterprise"
                
                $
                (0.13
                )
                $
                (0.12
                )
                $
                (0.14
                )Per
                    share amounts (diluted) of the tax benefit resulting from "Approved
                    Enterprise"
                
                $
                (0.12
                )
                $
                (0.12
                )
                $
                (0.13
                )
   F-41
  **ALADDIN
                KNOWLEDGE SYSTEMS LTD.**
 **AND
                SUBSIDIARIES**
  **NOTES
                TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
                dollars in thousands, except share and per share
                data**
 
 **NOTE
              13:-** **TAXES
              ON INCOME (Cont.)**
 j.
                  The
                      Company and its subsidiaries file income tax returns in various
                      jurisdictions. The Company and its subsidiaries are routinely
                      examined by
                      tax authorities in major jurisdictions. As of December 31,
                      2007, the
                      Company and its subsidiaries in Germany and Netherlands had
                      been examined
                      by the tax authorities through the calendar year 2002, the
                      Company’s
                      subsidiary in Japan had been examined by the tax authorities
                      through the
                      calendar year 2003 and the Company’s subsidiary in US had been examined by
                      Internal Revenue Service (IRS) through calendar year 2005.
  k.
                  The
                      Company adopted the provisions of FIN 48 as of January 1, 2007.
                      The impact
                      of adopting FIN 48 was insignificant impact on the Company's
                      consolidated
                      financial statements in the total estimated amount of $
                      182.
 
 Interest
          associated with uncertain income tax positions and penalties expense are
          classified as income tax expenses. The Company has not recorded any material
          interest or penalties during any of the years presented.
  A
          reconciliation of the beginning and ending balances of the total amounts
          of
          gross unrecognized tax benefits is as follows:
 Gross
                      unrecognized tax benefits at January 1, 2007
                  
                  $
                  1,762Increases
                      in tax positions for prior years
                  
                  
                  163Increases
                      in tax positions for current years
                  
                  
                  571Gross
                      unrecognized tax benefits at December 31, 2007
                  
                  $
                  2,496
  **NOTE
              14:-** **SHAREHOLDERS'
              EQUITY**
 
 a.
                    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.
 
 b.
                    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.
 
 c.
                    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 amount of $ 87, $ 51 and $ 15 was
                        recorded as
                        compensation expenses in the years 2004, 2005 and 2006,
                        respectively.
  d.
                In
                    April 2007, the Company initiated a share repurchase program,
                    in which the
                    Company is authorized to purchase up to $ 10,000 or for a maximum
                    of
                    500,000 of its outstanding Ordinary shares, through an open-market
                    transaction.
 
 In
          June
          and October 2007, the Company authorized additional share repurchase programs
          involving the repurchase from time to time of Ordinary Shares for an aggregate
          purchase price not to exceed $10,000 each.
  F-42
 **ALADDIN
              KNOWLEDGE SYSTEMS LTD.**
 **AND
              SUBSIDIARIES**
  **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
              dollars in thousands, except share and per share
              data**
 
 **NOTE
              14:-** **SHAREHOLDERS'
              EQUITY (Cont.)**
 
 As
          of
          December 31, 2007, the Company had purchased 928,697 of its outstanding
          Ordinary
          shares, at a weighted average price per share of $ 21.5 and for the total
          consideration of $19,986.
 
 Such
          repurchases of Ordinary shares are accounted for as Treasury shares, and
          result
          in a reduction of shareholders' equity.
 
 e.
                    Employee
                        Share Option Plans:
 
 Between
          1993 and 2007, the Company implemented several Employee Share Options Plans
          ("the plans"). Total number of options authorized for grant under the plans
          amounted to 3,773,750. As of December 31, 2007, an aggregate of 434,174
          options
          of the Company are 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 or the price 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.
 
 In
          January 2007, the Company’s board of directors approved an amendment to the
          Worldwide 2003 Share Option Plan pursuant to which the Company is authorized
          to
          grant to employees restricted share units (in addition to options to purchase
          shares initially authorized under the plan) in accordance with the terms of the
          plan. As of December 31, 2007 the Company has not yet granted to its employees
          restricted share units under the plan.
  F-43
 
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            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 stock option activity and related information for the
          year
          ended December 31, 2007, is as follows:
  **Number
                    of options**
                
                **Weighted-average
                    exercise price**
                
                **Weighted-
                    average remaining contractual term (in years)**
                
                **Aggregate
                    intrinsic value**Outstanding
                    at January 1, 2007
                
                
                1,107,131
                
                $
                11.63
                
                
                7.27
                
                $
                9,107Granted
                
                
                251,900
                
                $
                21.26Exercised
                
                
                (102,699
                )
                $
                7.05Forfeited
                
                
                (153,938
                )
                $
                19.27Outstanding
                    at December 31,2007
                
                
                1,102,394
                
                $
                13.19
                
                
                7.06
                
                $
                14,264Vested
                    and expected to vest
                
                
                990,964
                
                $
                12.52
                
                
                6.89
                
                $
                13,491Exercisable
                    at December 31,2007
                
                
                545,244
                
                $
                7.06
                
                
                5.42
                
                $
                10,398
 
 The
          weighted-average grant-date fair value of options granted during the twelve
          months ended December 31, 2006 and 2007 was $ 10.04 and $ 10.28,
          respectively. The aggregate intrinsic value in the table above represents
          the
          total intrinsic value (the difference between the fair market value of
          the
          Company ordinary shares on December 31, 2007 and the exercise price, multiplied
          by the number of in-the-money options) that would have been received by
          the
          option holders had all option holders exercised their options on December
          31,
          2007.
 
 Total
          intrinsic value of options exercised for the twelve months ended December
          31,
          2006 and 2007 was $ 3,030 and $ 1,959 respectively. As of December 31,
          2007, there was $ 1,979 of total unrecognized compensation cost related to
          non-vested share-based compensation arrangements granted under the Company's
          stock option plans. That cost is expected to be recognized over a
          weighted-average period of 1.51 years.
  F-44
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 Cash
          received from exercise of options for the years ended December 31, 2005,
          2006
          and 2007 were approximately $ 485, $ 835 and $724
          respectively.
 
 **NOTE
              14:-** **SHAREHOLDERS'
              EQUITY (Cont.)**
 The
          options outstanding as of December 31, 2007, have been separated into exercise
          price categories, as follows:
  **Options**
                
                **Weighted**
                
                
                
                **Options**
                
                **Weighted
                    average****outstanding**
                
                **average**
                
                **Weighted**
                
                **exercisable**
                
                **exercise****Range
                    of**
                
                **as
                    of**
                
                **remaining**
                
                **average**
                
                **as
                    of**
                
                **price
                    of****exercise**
                
                **December
                    31,**
                
                **contractual**
                
                **exercise**
                
                **December
                    31,**
                
                **options****price**
                
                **2007**
                
                **life
                    (years)**
                
                **price**
                
                **2007**
                
                **exercisable**$1.20-
                    2.67
                
                
                234,918
                
                
                5.12
                
                $
                1.72
                
                
                234,918
                
                $
                1.72$3.50-
                    4.80
                
                
                86,638
                
                
                3.51
                
                $
                4.29
                
                
                86,638
                
                $
                4.29$8.51
                    - 8.52
                
                
                103,388
                
                
                5.98
                
                $
                8.52
                
                
                103,388
                
                $
                8.52$13.05-
                    15.50
                
                
                109,000
                
                
                7.40
                
                $
                14.40
                
                
                46,975
                
                $
                14.61$16.23
                    - 18.00
                
                
                220,650
                
                
                8.21
                
                $
                17.42
                
                
                17,900
                
                $
                16.48$20.50
                    - 24.27
                
                
                347,800
                
                
                8.75
                
                $
                21.48
                
                
                55,425
                
                $
                21.861,102,394
                
                
                
                
                $
                13.19
                
                
                545,244
                
                $
                7.06
  f.
                    Dividends:
 
 In
          the
          event that cash dividends are declared in the future, such dividends will
          be
          paid in NIS. Based on its Board of Directors decision the Company does
          not
          intend to pay cash dividends in the foreseeable future.
  F-45
  **ALADDIN
          KNOWLEDGE SYSTEMS LTD.**
 **AND
          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**
 
 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, HASP SRM 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
          and OTP (One Time Password) devices 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.
 
 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.
 
 a.
                    The
                        following present segment results of operations for the years
                        ended
                        December 31, 2005, 2006 and 2007:
 
 **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Revenues
                    from external customers:Software
                    security (DRM)
                
                $
                56,578
                
                $
                60,556
                
                $
                66,097Enterprise
                    security
                
                
                25,195
                
                
                28,482
                
                
                39,785Consolidated
                    revenues
                
                $
                81,773
                
                $
                89,038
                
                $
                105,882Gross
                    profit:Software
                    security (DRM)
                
                $
                46,708
                
                $
                51,264
                
                $
                54,352Enterprise
                    security
                
                
                18,094
                
                
                17,761
                
                
                24,200Consolidated
                    gross profit
                
                $
                64,802
                
                $
                69,025
                
                $
                78,552Operating
                    income:Software
                    security (DRM)
                
                $
                20,501
                
                $
                24,135
                
                $
                25,066Enterprise
                    security
                
                
                (7,951
                )
                
                (10,929
                )
                
                (11,155
                )Consolidated
                    operating income
                
                $
                12,550
                
                $
                *)13,206
                
                $
                *)13,911Depreciation
                    and amortization:Software
                    security (DRM)
                
                $
                1,176
                
                $
                1,479
                
                $
                1,675Enterprise
                    security
                
                
                791
                
                
                937
                
                
                3,630Consolidated
                    depreciation and amortization
                
                $
                1,967
                
                $
                2,416
                
                $
                5,305
   F-46
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            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.)**
 *)  The
          impact of the stock-based compensation expense related to employee stock
          options
          as follows:
 
 **Year
                    ended December 31,****2006**
                
                **2007**Software
                    security (DRM)
                
                $
                1,246
                
                $
                377Enterprise
                    security
                
                
                1,022
                
                
                499Total
                    Stock-based compensation expense
                
                $
                2,268
                
                $
                876
 
 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,****2005**
                
                **2006**
                
                **2007**Revenues
                    from sales to unaffiliated customers:Israel
                
                $
                2,927
                
                $
                4,306
                
                $
                4,918United
                    States
                
                
                26,789
                
                
                23,426
                
                
                23,833Europe
                    (excluding Germany)
                
                
                21,471
                
                
                26,725
                
                
                34,269Germany
                
                
                17,129
                
                
                19,702
                
                
                24,839Japan
                
                
                9,345
                
                
                8,354
                
                
                7,437APAC
                
                
                1,577
                
                
                4,751
                
                
                8,506Others
                
                
                2,535
                
                
                1,774
                
                
                2,080$
                81,773
                
                $
                89,038
                
                $
                105,882Long-lived
                    assets:Israel
                
                $
                7,638
                
                $
                12,385
                
                $
                10,314United
                    States
                
                
                2,605
                
                
                2,567
                
                
                2,558Germany
                
                
                210
                
                
                359
                
                
                612Europe
                    (excluding Germany)
                
                
                2,048
                
                
                1,875
                
                
                1,706Japan
                
                
                260
                
                
                239
                
                
                208Others
                
                
                -
                
                
                -
                
                
                57$
                12,761
                
                $
                17,425
                
                $
                15,455
  F-47
 
 **NOTE
              15:-** **SEGMENTS
              OF THE COMPANY AND RELATED INFORMATION (Cont.)**
 
 c.
                Total
                    revenues from outside customers are distributed among the following
                    product lines:
 
 **Years
                    ended December 31,****2005**
                
                **2006**
                
                **2007**HASP
                    tokens
                
                $
                55,969
                
                $
                60,299
                
                $
                65,705eSafe
                
                
                11,162
                
                
                12,166
                
                
                14,654eToken
                
                
                14,032
                
                
                16,316
                
                
                25,131Others
                
                
                610
                
                
                257
                
                
                392$
                81,773
                
                $
                89,038
                
                $
                105,882
 **NOTE
          16:-**  **SELECTED
          STATEMENTS OF INCOME DATA**
 
 a.
                    Financial
                        income, net:
 **Years
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Financial
                    income:Interest
                    on marketable securities
                
                $
                616
                
                $
                1,384
                
                $
                672Interest
                
                
                1,244
                
                
                2,017
                
                
                2,766Gain
                    from derivative instruments
                
                
                456
                
                
                35
                
                
                185Gain
                    from marketable securities
                
                
                -
                
                
                183
                
                
                679Foreign
                    currency transaction gains
                
                
                -
                
                
                -
                
                
                1552,316
                
                
                3,619
                
                
                4,457Financial
                    expenses:Impairment
                    of available-for-sale marketable securities
                
                
                (117
                )
                
                -
                
                
                -Foreign
                    currency transaction losses
                
                
                (993
                )
                
                (176
                )
                
                -Other
                
                
                (168
                )
                
                (203
                )
                
                (183
                )(1,278
                )
                
                (379
                )
                
                (183
                )$
                1,038
                
                $
                3,240
                
                $
                4,274
 b.
                    Related
                        Party transactions:
 
 **Years
                    ended December 31,****2005**
                
                **2006**
                
                **2007**Cost
                    of revenues
                
                $
                116
                
                $
                158
                
                $
                127Research
                    and development
                
                
                8
                
                
                20
                
                
                395
 
 The
          Company purchases certain components and certain research and development
          services from an affiliate.
  F-48
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
          16:-**  **SELECTED
          STATEMENTS OF OPERATIONS DATA (Cont.)**
 
 c.
                    Earnings
                        per share:
 
 The
          following table sets forth the computation of basic and diluted net earnings
          per
          share:
 
 **Year
                    ended December 31,****2005**
                
                **2006**
                
                **2007**1.Numerator:Net
                    income
                
                $
                12,356
                
                $
                14,031
                
                $
                14,888Numerator
                    for basic and diluted net earnings per share
                
                $
                12,356
                
                $
                14,031
                
                $
                14,8882.Denominator:Weighted
                    average number of shares
                
                
                13,899
                
                
                14,596
                
                
                14,257Denominator
                    for basic net earnings per share
                
                
                13,899
                
                
                14,596
                
                
                14,257Effect
                    of dilutive securities:Employee
                    stock options
                
                
                681
                
                
                482
                
                
                406Denominator
                    for diluted net earnings per share - adjusted weighted average
                    shares,
                    assuming exercise of options
                
                
                14,580
                
                
                15,078
                
                
                14,663
 
 F-49
 **ALADDIN
            KNOWLEDGE SYSTEMS LTD.**
 **AND
            SUBSIDIARIES**
  **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **U.S.
            dollars in thousands, except share and per share
            data**
 
 **NOTE
          17:-**  **SUBSEQUENT
          EVENTS**
 
 On
          January 18 th ,
          2008,
          the Company invested a total amount of $3,000, in Athena. Following the
          closing,
          the Company will increase its aggregate holdings in Athena to 38.8% of
          Athena's
          share capital.
 
 Additionally,
          the Company received a certain purchase option that allows it to acquire
          the
          entire share capital of Athena from its current shareholders in 2011 for
          consideration to be based on Athena's performance in the year 2010.
 
 Furthermore,
          in order to prevent a takeover of Athena before the Company’s purchase option
          comes into effect, the agreement provides that in the event that any other
          party
          offers to purchase the entire share capital of Athena at any time before
          the end
          of 2010, the Company shall have a right of first refusal to purchase all
          the
          shares of the other shareholders instead of such offeror, at a 20% discount.
          This right of first refusal will also apply to any offers by third parties
          to
          acquire any substantial part of the business, assets or intellectual property
          of
          Athena, including by way of merger.
 
 The
          Company was also granted the right to appoint one director (out of five)
          to
          Athena's board.
 
 Due
          to
          the above mentioned investment and related rights, the Company will consolidate
          Athena from the closing date of the additional investment based on the
          guidance of Financial Accounting Standards Board (“FASB”) Interpretation
          No. 46R (“FIN 46R”), “ *Consolidation
          of Variable Interest Entities, an Interpretation of Accounting Research
          Bulletin
          No. 51”* ,
          as
          revised from FIN 46.
 
 Athena
          is
          considered a Variable Interest Entity (“VIE”) since it lack’s
          sufficient equity to finance its planned activities without additional
          financial
          support. Further, the Company is considered the primary
          beneficiary of Athena’s operations as it shares most of the risks
          and
          rewards of Athena.
 
 F-50
 
 **REPORT
          OF INDEPENDENT AUDITORS**
 
 **To
          the shareholders of**
 
 **ALADDIN
          EUROPE LTD**
 
 We
          have
          audited the accompanying balance sheets of Aladdin Europe Ltd ("the Company"),
          as of December 31, 2006 and 2007, and the related statements of operations
          and
          shareholders' equity and cash flows for each of the three years in the
          period
          ended December 31, 2007. 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, 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, 2006
          and 2007 and the results of its operations and its cash flows for each
          of the
          three years in the period ended December 31, 2007, in conformity with U.S.
          generally accepted accounting principles.
 **BLICK
                      ROTHENBERG**
                  12
                      York GateChartered
                      Accountants
                  Regent’s
                      ParkRegistered
                      Auditors
                  LondonNW1
                      4QS27th
                      March, 2008
 F-51
  **EXHIBIT
        INDEX**
  1.1
              Articles
                  of Association, as amended, dated February 6, 2005(1)
 
 1.2
              Memorandum
                  of Association of the registrant.(2)(3)
 
 4
              Form
                  of Indemnification Agreement between the registrant and each of
                  the
                  members of its board of directors and its officers.(4)
 
 8
              List
                  of subsidiaries.*
 
 11
              Code
                  of Ethics(4)
 
 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.*
 
 15.1
              Consent
                  letter from Kost, Forer, Gabbay & Kasierer
                  *
 
 15.2
              Consent
                  letter from Blick Rothenberg *
  **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 2003 Annual Report on Form 20-F filed with
                  the
                  Commission on June 30, 2004.*
  71