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SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

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FORM 20-F

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

For
the fiscal year ended December 31, 2002.                                  Commission File No. 1-8201

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

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Israel
(Jurisdiction
of incorporation or organization)

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

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

None

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

Ordinary Shares, nominal value 0.01 New Israeli Shekel per
share
(Title
of Class)

Securities for which there is a reporting obligation pursuant
to Section 15(d) of the Act:

None
(Title
of Class)

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Indicate the number of
outstanding shares of each of the issuers classes of capital or common stock
as of the close of the period covered by the annual report:

11,477,922
Ordinary Shares

Indicate by check mark
whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements for the
past 90 days:

Yes
þ
No
o

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

Item 17
o
Item 18
þ

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This annual report on
Form 20-F includes certain forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934.  The use of the words project, expect, may, plan or
intend, or words of similar import, identifies a statement as
forward-looking.  There can be no assurance,
however, that actual results will not differ materially from our expectations
or projections.  Factors that could
cause actual results to differ from our expectations or projections include the
risks and uncertainties relating to our business described in this annual
report in Item 3 Risk Factors.

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

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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

Selected Financial Data

The selected financial
data is incorporated by reference to Item 5 of this annual report.

Risk Factors

This annual report and
statements that we may make from time to time may contain forward-looking
information.  There can be no assurance
that actual results will not differ materially from our expectations,
statements or projections.  Factors that
could cause actual results to differ from our expectations, statements or
projections include the risks and uncertainties relating to our business
described below.

Risk
Factors Related to our Business

We have a recent history of operating losses.

We have a recent history
of operating losses.  The revenue and
profit potential of three of our products, eSafe, eToken and Privilege, are
unproven.  All three of these products
have been released recently and the revenues from these products are difficult
to predict. In July 2001, we acquired certain assets of Preview Systems Inc.s
electronic software distribution business, which increased our expenses and has
a history of losses.  Any revenues from
our acquisition of Preview are difficult to predict.  We believe that the amount of cash and cash equivalents in our
bank account is sufficient to support our current growth plans.  We have no commitments to receive additional
financing and due to our recent history of operating losses, it may be
difficult for us to obtain additional financing.

We face intensive competition in our industry.

The software protection
industry is highly competitive.  In the
token-based software security market, our primary direct competitors are Rainbow
Technologies Inc. and WiBu Systems. In addition to these primary
competitors, we face competition from over twenty other software companies.  Although we believe that the features and
functions of our products are favorably distinguishable from those of our
competitors, we cannot be sure that we will be able to further expand our
market share or that we will be able to maintain our current market share.
Furthermore, we cannot guarantee that we will be successful in our efforts to
develop products with innovative features and functions, or that competitive
pressures will not result in price reductions that could negatively affect our
business in both the token-based software security and Privilege markets.

3

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The Internet security
industry is also highly competitive. 
Our primary competitor in the content security and anti-virus market
is Trend Micro Inc. In addition, we face new competition from
anti-spam companies that offer email content security solutions with plugs-ins
for existing anti-virus products.   If
we are unable to provide customers with prompt solutions to new viruses and
vandals, our current and potential customers may choose to buy products and
services from our competitors.  Since
both anti-virus and anti-vandal software are adaptable to most computer systems
and software, customers may change products if they determine that other
products better suit their needs.

The Internet service
provider segment of the software distribution industry is very
competitive.  We provide infrastructure
solutions for electronic software distribution. Our primary competitor in this
segment is Macrovision Corporation. 
Because this is a relatively new market, in the future we may face
competition from other software developers.

In addition, software
developers and operating system vendors such as Microsoft have added features
to new versions of their operating systems and software that are designed to
limit intrusions by unauthorized users or viruses and vandals via the
Internet. Furthermore, it has recently been announced that Microsoft is acquiring anti-virus technology which will
eventually evolve into a fee-based service on future Windows platforms, which would increase the high-level
of competition we currently face. As the incorporation of such
features in future versions of operating systems and software make these
systems less susceptible to outside penetration, there may be a decrease in the
demand for our products. Although we believe that these solutions are less
attractive than our products because they cannot be upgraded on a timely basis
to address new viruses and vandals, we cannot guarantee that we will be able to
convince our current and potential customers of the benefits of our dedicated
anti-virus and anti-vandal solutions.

Many of our competitors
have substantially greater capital resources, research and development staffs,
facilities, marketing and distribution networks and name recognition as well as
more extensive customer bases.  While we
plan to continue to improve our products, we cannot guarantee that we will
successfully differentiate our products from those of our competitors or that
the marketplace will consider our products superior to those of our
competitors.

We rely on independent distributors for a portion of our
revenues.

Approximately 22.6%, of
our revenues in 2002 were generated from sales to our independent
distributors.  Although none of our distributors
accounted for more than 10% of our sales, if we lose or decrease the volume of
sales to our distributors, our total sales could materially decrease.  In addition, we intend to sign additional
distribution agreements in the future, which may make us more dependent on our
distributors.  There can be no assurance
that our distributors will devote sufficient resources to market our products
effectively.

We may not be able to respond in a timely manner to our
customer complaints due to our indirect relationship with some of our
customers.

Although we maintain
control of the distribution codes for each of our customers, our relationship
with the end-users of our products is often indirect.  In many markets we primarily rely on our distributors and partners
to interact with customers.  As a
result, we may not learn of customer satisfaction or dissatisfaction with our
products and, therefore, may not be able to respond quickly to specific market
needs, which may negatively affect our results of operations.

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We rely on a limited number of suppliers and subcontractors.

Most of the parts and
components that are used to manufacture and assemble our software protection
products are available from several sources, although we do purchase certain
components from single source suppliers. 
We believe that we have sufficient inventory of these components to meet
our foreseeable needs. If we are forced to use alternative parts or components,
we might have to make certain changes in the design of products that use such
components, which could result in delays and interruptions in shipments and
could adversely affect our operating results. 
We use a single subcontractor to manufacture our proprietary application specific integrated circuits or
ASICs.  Our Hardlock and
Microguard lines of products also contain proprietary ASICs, which are supplied
by additional single source suppliers. 
If any of these suppliers cease to produce ASICs for us, the
manufacturing of our ASICs would have to be transferred to another supplier or
suppliers.  Such a transfer may take
several months and would delay the production and supply of our products, which
could seriously harm our results of operations.

Some of our production costs are fixed.

Some of our production
costs are fixed costs.  Consequently, in
the event of an economic slowdown that results in a decrease in the sales of
our products, we will not be able to eliminate our fixed production costs.  Our inability to completely reduce our
production costs in response to market trends may cause a reduction in our
profit margin, which could seriously harm our results of operations.

We are subject to several risks as a result of our
international sales.

To date, our products
have been sold primarily in Europe, North America, the Far East and
Israel.  We are subject to all of the
risks inherent in international business activities including the
following:

| |  | unexpected changes in regulatory requirements,
  tariffs and other trade barriers;            
| | - | ----------------------------------------------------------------------------------------------
| |   |                                                                                               
| |  | difficulties in staffing and managing foreign
  operations;                                   
| |   |                                                                                               
| |  | political instability;                                                                        
| |   |                                                                                               
| |  | fluctuations in currency exchange rates or
  restrictions on conversion of foreign currencies;
| |   |                                                                                               
| |  | reduced protection for intellectual property rights
  in some countries;                      
| |   |                                                                                               
| |  | burdens with complying with a wide variety of
  foreign laws and regulations;                 
| |   |                                                                                               
| |  | potentially adverse tax consequences; and                                                     
| |   |                                                                                               
| |  | the spread of epidemics such as SARS (Severe Acute
  Respiratory Syndrome).                   

In addition, if we fail
to obtain approvals from foreign governmental bodies, our sales revenues and
results of operations could be negatively affected.  To date, we generally have not experienced any material
difficulties in collecting accounts receivable as a result of our international
sales.

The spread of the SARS epidemic could seriously harm our
profitability in Asia.

SARS is a Flu-like virus
which first appeared in China in November 2002. To date, there have been
thousands of cases reported worldwide with hundreds of fatalities. Due to the
ease with which SARS can spread, medical experts recommend placing people who
have contracted SARS into quarantine. People who may have come into contact
with SARS are also being placed into quarantine for a 2 week period until it
can be confirmed that they have not contracted SARS. Although there have been
cases of SARS reported in various regions, SARS is most prominent in Asia and
specifically China and Hong Kong. The spread of SARS has resulted in a business
slowdown that has been felt most prominently in China. There is no way of
knowing when the global spread of SARS will be brought under control. If the
situation persists or worsens, it could seriously damage our sales in Asia, and
particularly China.  Although the
substantial majority of our sales are not made in Asia, our profitability in
Asia has been hurt by the effects of the epidemic on the region.

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If our maintenance and upgrades to our product disrupts our
customers operations, we may suffer lost revenues and harm to our reputation.

We need to upgrade and
improve our products periodically. Upgrading or deploying a new version of a
product requires the cooperation of our existing customers and their network
participants.  These network
participants may be reluctant to upgrade our product since this process can be
complicated and time consuming and poses the risk of network failures.  If our periodic upgrades and maintenance
cause disruptions, we may lose revenue-generating transactions, our customers
may elect to use other solutions and we may also be the subject of negative
publicity that may adversely affect our business and reputation.

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, changes in end-user requirements and sophisticated hackers
constantly improving their methods of stealing end-user technology and
software.  Therefore, our future success
will depend upon our ability to enhance our existing products and to develop
and introduce products that achieve market acceptance.  In order to meet this challenge, we put a
great emphasis on research and development. These efforts have enabled us to
market three new products since September 1999 (eSafe, eToken and Privilege)
and to adapt to a constantly changing market. 
However, there can be no assurance that we will timely or successfully
complete the development of new or enhanced products or successfully manage
transactions from one product release to the next, or that our future product
will achieve market acceptance.

We may not be able to protect our intellectual proprietary
rights

Our success and ability
to compete greatly depends on our proprietary technology.  We rely on a combination of patents and
trade secrets, copyright and trademark laws, together with non-disclosure
agreements, confidentiality clauses in our agreements and technical measures to
establish and protect proprietary rights in our products. In addition, we
currently have 17 registered patents and 31 pending applications in the United
States.  We also have 2 registered
patents and 30 pending applications outside of the United States.  To license our products, we primarily 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.  Although we are not aware of any material infringements of our intellectual property,
we have recently become aware of and are currently investigating the possibility that one of our former Asian
distributors is infringing our intellectual property.  Should we come to the conclusion that our
intellectual property is being infringed upon, we would take appropriate steps to protect our
intellectual property. However, both in this specific case and in general, we cannot guarantee that we will
successfully protect our technology because:

| |  | some foreign countries may not protect our
  proprietary rights as fully as do the laws of the United States;                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                                                    
| |  | if a competitor were to infringe on our proprietary
  rights, enforcing our rights may be time consuming and costly, diverting both
  our managements attention and our resources;
| |   |                                                                                                                                                                                    
| |  | measures like entering into non-disclosure
  agreements afford only limited protection;                                                                                            

6

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| |  | 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 may not be able to avoid others from successfully
claiming that we infringed their proprietary rights.

Significant and
protracted litigation may be necessary to protect our intellectual property
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.  We have not completed an in-depth exhaustive
analysis of such patents or applications. 
Some of our competitors have extensive patent portfolios 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 it is issued
in the future.

To address any patent
infringement or other intellectual property claims, we may have to redesign our
products to avoid infringement or enter into royalty or licensing agreements on
disadvantageous commercial terms. We may be unable to successfully redesign our
products or obtain a necessary license. In addition, any infringement or other
intellectual property claims, with or without merit, which are brought against
us could be time consuming and expensive to litigate or settle and could divert
managements attention from our business. 
We are currently involved in one patent infringement claim (see Item 8: Financial Information  Legal
Proceedings).

Some of the products we produce may contain undetected
errors or failures

Software products as
complex as those which we offer, may frequently contain undetected errors or
failures, especially when first introduced or when new versions are
released.  Despite the extensive product
testing which we conduct, some of our products could contain software errors,
defects or viruses, or otherwise fail to meet customer specifications. Any
product defects in our existing or new products may result in loss or deferral
of our revenues, diversion of our resources, damage to our reputation, or
increased service and other costs.  In
order to limit our liability, most of our end-user license agreements, our
distribution agreements and reseller agreements contain limitation of
liabilities clauses for indirect or incidental damages arising out of the use
of our product.

Our software protection products are vulnerable to piracy.

Like the products of
other developers of software security products, our software security 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 increasingly
serious hacking problems, resulting from the development by hackers of methods
to circumvent some parts of our software protection products.  Such methods are often publicized over the
Internet, making them readily available to those who wish to make unlicensed
copies of our customers software.  We
are constantly in the process of developing and releasing solutions designed to
respond to our customers complaints and handle hacking problems.  Although, to date, we have been successful
in developing effective solutions to these problems, 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.

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We may be subject to product liability claims by our
customers.

Our Internet content
security products, specifically eSafe, are designed to protect our customers
computer systems and restricted websites from unauthorized access and from
malicious and inappropriate content such as vandals, viruses and worms.  This malicious content can cause irreparable
harm to our customers computer systems and businesses.  Although we believe that widespread
hacking of our products, including eSafe, is not economically feasible based on commercially available
computer equipment, should hackers manage to bypass our products security
features, effected customers could face irreparable harm. In addition, our
software protection products are used to protect software from unauthorized
use; if our products are ineffective, our customers may lose substantial revenues
due to software piracy. As a result of damages they incur or lost revenues,
customers may bring product liability and related claims against us. Such
claims brought against us, whether valid or not could negatively affect our
business operating results and our reputation as well as divert management time
and resources. Although most of our sales agreements contain provisions
designed to limit our exposure to potential product liability or related
claims, in selling our products, we rely primarily on shrink wrap licenses
that are not signed by our customers, which may be unenforceable under the laws
of certain jurisdictions. As a result, the limitation of liability provisions
contained in these agreements may not be effective.

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

We have in the past grown
through acquisitions. Most recently, we acquired assets of Preview Systems
Inc.s electronic software distribution business. Although, we currently have
no plans for any acquisitions, this may change and the process of integrating
any acquired business into our business and operations is risky and may create
unforeseen operating difficulties and expenditures. The areas in which we may
face difficulties include:

| |  | diversion of our management time after consummation
  of the acquisition from the ongoing development of our businesses, and the
  release of future products and services;                                                                             
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                                                                                                                         
| |  | 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                        
| |   |                                                                                                                                                                                                                                                         
| |  | the need to integrate new product lines and
  accounting, management information, human resource and other administrative
  systems to permit effective management, and the risk of disorganization if
  this integration is delayed or not implemented.

Future acquisitions could
also result in potentially dilutive issuances of equity securities, the
incurrence of additional debt, contingent liabilities or impairment related to
goodwill and other intangible assets, any of which could harm our business.
Future acquisitions also 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.

We are subject to certain government controls in the export
of our technologies and products.

As a result of our
research and development activities in Israel, we are required to obtain export
permission from the Israeli government before exporting certain technologies.We
have recently received governmental permission to manufacture and export the
eToken R2 and eToken PRO. We believe that all other products we currently
market do not require such approval. 
However, we may require approval to sell certain products that are
currently under development, including encryption technology and future
versions of eToken.  In addition,
Israeli encryption regulations are subject to change and updates.  We cannot guarantee that we will be
successful in obtaining approvals we may apply for in the future, or that we
will obtain these approvals in a timely manner; failure to obtain such
approvals in a timely manner could negatively effect our business and operating
results.

8

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Terrorist attacks that occurred in United States on
September 11, 2001, the war in Iraq and other acts of violence or war may
materially affect the markets in which we operate.

In the aftermath of the
September 11, 2001 terrorist attacks on the United States, the United
States-led coalition of nations commenced a series of retaliatory military
strikes in Afghanistan upon strategic installations of the Taliban regime, and
governmental intelligence authorities issue from time to time warnings of the
imminent threat of further attacks against civilian and military installations.
On March 17, 2003, a coalition of countries led by the United States and the
United Kingdom commenced large scale military action against Iraq with the
avowed purpose of effecting a change in the Iraqi regime. Now that the war in
Iraq has concluded, and the regime of Saddam Hussein has collapsed, the United
States and other nations have undertaken to rebuild Iraq into a stable
democratic country. These attacks, armed conflicts and their aftermath, as well
as the uncertainty surrounding these issues, have had, and we expect will
continue for the unforeseeable future to have, an adverse effect on the global
economy, and the software industry and could result in a disruption of our
business or that of our customers. In addition, these events may discourage
foreign technical experts and foreign employees, upon whom we rely for support
and maintenance from traveling to our facilities in Israel, which could have an
adverse affect on our business performance.

Although to date our
business has not been materially affected by these factors, there can be no
guarantee that we will not be adversely affected in the future.

Corporate governance scandals and new legislation could
increase the cost of our operations.

As a result of recent
United States corporate governance scandals and the legislative and litigation
environment resulting from those scandals, the costs of being a public company
traded on the United States markets are expected to increase in the near
future. Specifically, new legislation, such as the recently enacted
Sarbanes-Oxley Act of 2002, will have the effect of increasing the burdens and
potential liabilities of being a public reporting company. This and other
proposed legislation may require additional management resources and increase
the fees of our professional advisors as well as our insurance premiums.

Risks
Related to our Ordinary Shares

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

The market prices of our
ordinary shares are subject to fluctuations. 
The following factors may significantly impact the market price of our
ordinary shares:

| |  | quarter-to-quarter fluctuations in our financial
  results;         
| | - | --------------------------------------------------------------------
| |   |                                                                     
| |  | under or over performance against analysts
  estimates;            
| |   |                                                                     
| |  | changing laws and government regulations relating to
  our business;

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| |  | increased market share penetration by our
  competitors;                         
| | - | ---------------------------------------------------------------------------------
| |   |                                                                                  
| |  | general economic conditions;                                                     
| |   |                                                                                  
| |  | increased operating costs, particularly with regard
  to machinery and personnel;
| |   |                                                                                  
| |  | additions or departures of key personnel;                                        
| |   |                                                                                  
| |  | sales of additional ordinary shares;                                             
| |   |                                                                                  
| |  | political, economic or other developments affecting
  Israel; and                
| |   |                                                                                  
| |  | stock market volatility.                                                         

Our results are affected by volatility in the securities
markets, which may affect our ability to raise additional financing.

Due to the continuing
weakening in the world economy, including as a result of the September 11, 2001
terrorist attacks and their aftermath, the securities markets have recently
experienced volatility, which has particularly affected the market prices of
equity securities of many high-technology companies, including companies having
a significant presence in Israel.  This
volatility is often unrelated or disproportionate to the operating performance
of these companies.  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 affect our
ability to raise additional financing in the future.

We may fail to meet the maintenance
standards for the NASDAQ National Market.

Our ordinary shares are
currently traded on the NASDAQ National Market.  If we are unable to maintain the requirements for continued
listing on the NASDAQ National   
Market, our ordinary shares could be delisted from trading on this
market.  Consequently, selling (and
buying) our securities would be more difficult because of:

| |  | delays in the timing of transactions;                                                    
| | - | -----------------------------------------------------------------------------------------
| |   |                                                                                          
| |  | greater difficulty in disposing of securities and
  obtaining accurate quotations; and   
| |   |                                                                                          
| |  | possible reduction in security analysts and the
  news medias coverage of our business.

These factors could
result in lower prices and larger spreads in the bid and ask prices for our
ordinary shares than might otherwise be obtained.

If our ordinary shares
were delisted from the NASDAQ National Market, we would seek to have the
ordinary shares traded in the NASDAQ SmallCap Market or another national securities
exchange.  However, we cannot assure you
that we would be able to obtain an alternative listing for our ordinary shares.

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Risks
Related to our Operations in Israel

We benefit from certain tax benefits that may change or be
withdrawn.

Four
of our six expansion programs are currently eligible for certain tax benefits
under The Law of Encouragement for Capital Investments (see Item 10:
Additional Information- Taxation and Note 13d. to our Financial Statements).
To be eligible for these tax benefits, we must continue to meet certain
conditions, including making certain specified investments in property and
equipment out of our own equity. If we fail to meet such conditions in the
future, we could be required to pay certain taxes.  There can be no assurance that such tax benefits will be
continued in the future, at the current levels or otherwise. The termination or
reduction of certain tax benefits could have a material adverse effect on our
business, results of operations and financial condition.

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

All our manufacturing
facilities and our corporate and primary sales offices are located in
Israel.  Accordingly, security,
political and economic conditions in Israel may directly affect our business,
results of operations and financial and condition.
Since the establishment
of the State of Israel in 1948, a number of armed conflicts have taken place
between Israel and its Arab neighbors, as well as incidents of civil unrest. In
addition, Israel and companies doing business with Israel have, in the past,
been the subject of an economic boycott. Although Israel has entered into
various agreements with Egypt, Jordan and the Palestinian Authority, there has
been an increase in unrest and terrorist activity which began in September 2000
and which has continued with varying levels of severity into 2003. Certain
parties with whom we do business have declined to travel to Israel during
periods of heightened unrest or tension, forcing us to make alternative
arrangements where necessary. We do not believe that the political and security
situation has had any material impact on our business to date as a large
portion of our business is overseas; however, we can give no assurance that
security and political conditions will have no such effect in the future. Any
hostilities involving Israel or the interruption or curtailment of trade
between Israel and its present trading partners could adversely affect our
operations and could make it more difficult for us to raise capital.In addition, Israel
has recently experienced a wave of unionized general strikes, in connection
with economic reforms being passed into legislation. Due to the fact that our
products are manufactured in Israel and, for the most part, sold to customers
outside of Israel, a prolonged general strike in which ports are shut down
would affect our ability to deliver our products to our non-Israeli customers.
Although, we have a contingency plan that would allow us to manufacture our
products in Germany, we cannot guarantee that a prolonged general strike would
not have a material adverse effect on our business, results of operations and
financial conditions.

Many of our employees in Israel are obligated to perform
military reserve duty.

In the event of severe unrest or other
conflict, many of our Israeli male employees could be required to serve in the
military for extended periods of time. In response to the increase in terrorist
activity and the renewed Palestinian uprising, there has been a significant
call up of military reservists, and it is possible that there will be
additional call-ups in the future. While we have operated effectively despite
these conditions in the past, we cannot assess what impact these conditions may
have in the future, particularly if emergency circumstances arise.

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Israeli courts may not enforce judgments rendered outside of
Israel.

Service of process upon
our directors and officers, all of who reside outside the United States, may be
difficult to effect within the United States. 
Furthermore, since the majority of our assets are located outside the
United States, any judgment obtained against us in the United States may not be
enforceable outside the United States. 
There is doubt as to the enforceability of civil liabilities under the
Securities Act and the Exchange Act in original actions instituted in
Israel.  However, subject to certain
time limitations, Israeli courts may enforce United States final executory
judgments for liquidated amounts in civil matters obtained after due trial
before a court of competent jurisdiction (according to the rules of private
international law currently prevailing in Israel) which enforces similar
Israeli judgments, provided that certain procedural and legal requirements are
adhered to.

Item
4.               Information
on the Company

History and development of the Company

Aladdin Knowledge Systems
Ltd. is a leader in securing digital content, from applications software to
Internet use and access.  We develop and
market three lines of token-based software security systems: HASP (Hardware
Against Software Piracy), Hardlock and MicroGuard. Our HASP, Hardlock and
MicroGuard systems, which include both software and hardware, protect our
customers software against unauthorized copying and illegal use by requiring
software users to insert our tokens into their computers before they can use
the protected software.  We also develop
and market Privilege, a software distribution and licensing tool. Privilege
provides a comprehensive, flexible infrastructure solution for managing,
selling and fulfilling orders for software products over the Internet.  These products allow for secure software
distribution over the Internet without restricting the different ways our
customers do business.

We also develop and
market a family of products called eSafe that provide content security
solutions for Internet users.  Our
Internet eSafe security products provide users with comprehensive protection
against Internet content security threats such as viruses, vandals and trojans
that can, among other things, destroy data, crash critical systems, redirect or
hijack modems or steal vital information such as passwords and credit card
details.  We released the eToken R2 and
the eToken Pro secure authentication devices, which are the size of a house key, and the accompanying software, eToken
Enterprise.  eToken ensures that only legitimate users gain access to
computers or network resources by requiring its insertion in the computers
universal serial bus (USB) port and the entering of a single password.

Our legal and commercial
name is Aladdin Knowledge Systems Ltd. 
We were incorporated in Israel in 1985 and organized pursuant to the
Israel Companies Ordinance, which was replaced in February 2000 by the Israel
Companies Law.  Our principal executive
offices are located at 15 Beit Oved Street, P.O. Box 11141, Tel Aviv, Israel
61110, and our telephone number is 972-3-636-2222.  Our Internet addresses are: http://www.eAladdin.com, and
http://www.aks.com.  Information on our
web site is not incorporated by reference in this annual report.

12

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The following is a
description of our recent expenditures, investments and acquisitions and other
developments in our company:

Acquisitions

| | In July 2001, we acquired certain assets (and
  assumed certain liabilities) of Preview Systems, Inc.s electronic software
  distribution business for $5.2 million. In conjunction with the acquisition,
  Preview granted us worldwide, non-exclusive licenses with the right to sublicense
  for the products we purchased from them. 
  We have the exclusive rights to use the Preview Systems trademark
  and the Preview trademark and logo has been assigned to us. In addition, we
  have begun to market the Preview products under our Privilege line of
  products.  (See Note 1b. to our
  Financial Statements).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | In February 2000, we acquired all the outstanding
  shares of our independent distributor in France, Aladdin France S.A. for
  $678,000, and certain eSafe related assets from Commerce Technologe
  International for $370,000. We then merged the two operations into one single
  wholly owned subsidiary, Aladdin France S.A. (See Note 1c. to our Financial
  Statements).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | In March 1999, we acquired substantially all of the
  assets of Micro Macro Technologies Ltd. 
  Micro Macro develops and markets token-based software security systems
  primarily for Macintosh software developers. 
  At the time of our acquisition Micro Macro was in the process of
  liquidation and we paid the receivers $700,000 for its assets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | In December, 1998, we signed a strategic agreement
  with Athena Research Ltd. (our former partner in Aladdin Knowledge Systems
  Japan Co.), under which we formed a joint venture named Athena Smartcard
  Solutions Ltd. which develops and markets smartcard solutions based on our
  Smartcard Environment (ASE) technology. 
  Pursuant to this agreement, we granted Athena Smartcard Solutions a
  non-exclusive, perpetual license (that became an exclusive perpetual license
  under a technology license agreement entered into between us and Athena
  effective as of May, 2001) to use the ASE technology and all related
  intellectual property, and Athena Smartcard Solutions assumed all of the
  responsibilities for our ASE related business, including marketing, sales and
  customer support.  We have ceased all
  of our in-house activities with respect to the ASE technology field.  Athena Smartcard Solutions issued us
  shares representing 33% of its total issued and outstanding shares.  Between December 1998 and December 31, 2002,
  we provided Athena loans in the aggregate amount of $2,383,000.  In the first half of 2003 we provided
  Athena with an additional $100,000 loan.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|  | On March 28, 2001, we converted $1,053,000 into a
  convertible bond redeemable at the earlier of five years from the date of
  grant or at such time as Athena completes an equity financing in the amount
  of $2 million. The bond is convertible into 53 Athena Class A preferred
  shares, par value JPY 50,000 (approximately $420) per share. The remaining
  $1,430,000 constitutes long-term debt. 
  We are currently finalizing an agreement with Athena on the basis of
  the understanding we have reached with them concerning the repayment terms of
  such long-term debt.  Part of the
  understanding that we have reached with Athena is that in addition to the
  repayment of our loans, Athena will pay us royalties with respect to their
  future product sales.  As of May 31,
  2003, we own 35.71% of Athena and the aggregate outstanding debt owed Aladdin
  by Athena is $2,483,000.  We have made
  a provision in our financial statements with respect to the likelihood that
  Athena will be able to repay its debt to us.                                                                                                                                                                   

13

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Investments

| | On October 2, 2000, our board of directors approved
  a plan to repurchase ordinary shares in our company in the amount of $3
  million.  Through 2001, we spent
  $1,163,904 on the repurchase of 224,100 ordinary shares and have since
  stopped repurchasing the stock in our company.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In February 2000, we entered
  into a Strategic Investor Agreement pursuant to which we agreed to commit $10
  million to Tamir Fishman Ventures II LLC as follows: approximately $8 million
  on demand to Tamir Fishman Ventures II (Israel) LP and we agreed to make
  approximately $2 million available to our senior executives, for them to
  invest in Tamir Fishman Venture Capital II Ltd. on the day prior to its
  public offering on the Tel Aviv Stock Exchange, and in a Delaware limited
  partnership related to Tamir Fishman Ventures II LLC.  In August 2000, we subscribed for
  $8,025,000 of partnership units in Tamir Fishman Ventures II (Israel)
  L.P.  In addition, as of December 31,
  2001, we loaned approximately $1,150,000 to several of our officers to invest
  in Tamir Fishman Venture Capital II Ltd. 
  As of December 31, 2002, our U.S. subsidiary, Aladdin Knowledge
  Systems, Inc. loaned approximately $124,000 to its senior management to
  invest in the Delaware limited partnership. 
  This loan is to be part of a $450,000 investment that such employees
  committed to invest in the Delaware limited partnership.  These loan programs were cancelled
  in January, 2002.  Our employees (and
  former employees) transferred their shares in Tamir Fishman Venture Capital
  II Ltd to Aladdin in return for the waiver of the commitment of the employees
  regarding the loans granted to them by us. We are currently concluding
  similar arrangements for our US subsidiary. (including a former employee)
  (See Item 7: Related Party Transactions  Loan Agreements with Officers). 
  Together with our US subsidiary, as of May 31, 2003 we have invested a
  total of $4,150,000  in
  Tamir Fishman Ventures II (Israel) L.P. and in a Delaware limited partnership
  related to Tamir Fishman Ventures II LLC, which represents close to half of
  our total commitment to these entities.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | On December 29, 1999, we purchased shares
  representing 7.18% of the outstanding shares of Comsec Information Security
  Ltd., an Israel-based information security-consulting firm, for approximately
  $1,722,050.  In February 2000, Comsec
  consummated an initial public offering. 
  The fair market value of our investment in Comsec as of December 31,
  2002 is $572,000.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | Effective December 31, 2000, we converted a
  Subordinated Promissory Note in the amount of DM 18,311,791.96 (US
  $8,708,220) into 1,741,644 Series C preferred shares in FAST Multimedia Inc.,
  which represents 11.93% of the outstanding share capital of FAST Multimedia
  Inc.  We received the promissory note
  as part of our acquisition of FAST Software Security AG in 1996.  We consented to the transfer of the
  payment of the principal of the promissory note from FAST Software Security
  AG to its parent company FAST Multimedia Inc. on January 19, 2001. In
  connection with the purchase of FASTS digital video editing hardware and
  software business, Fast Multimedia Inc. purchased a promissory note issued by
  FAST in the aggregate principal amount of DM 2.5 million ($1.6 million). This
  note was repaid by FAST in June 1995 through the sale by FAST to FAST
  Multimedia Inc. of certain subsidiaries of FAST. In 2001, we wrote off our
  portion of the FAST note in the aggregate amount of $3,350,000. At the end of
  2001 FAST Multimedia was acquired by Pinnacle Systems. In May 2002, we
  received $261,000 as our share of this deal. (See Item 8: Related Party
  Transactions  FAST Multimedia).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

Business Overview

Products

Software Security

Development of software
applications requires software developers to make major investments in time,
money and other resources.  Software
piracy denies software developers of much of the returns on their investment.  In addition, it harms paying customers, who
ultimately bear a substantial portion of the cost of illegal use in the form of
higher license fees.  Software piracy
can occur in many forms, including:

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| | end-users making unauthorized copies of software at
  work or at home;           
|- | ---------------------------------------------------------------------------------
|  |                                                                                  
| | retailers selling illegal copies;                                                
|  |                                                                                  
| | computer dealers loading illegal copies onto their
  customers hardware;        
|  |                                                                                  
| | bulletin board operators and subscribers offering
  software for illegal copying;
|  |                                                                                  
| | commercial counterfeiters offering illegally copied
  software for sale; and     
|  |                                                                                  
| | companies exceeding the number of users authorized
  by network licenses.        

According to the seventh
annual independent study on global software piracy commissioned by the Business
Software Alliance the global software industrys losses due to the illegal use
and duplication of business software reached $10.97 billion in the year 2001.
North America, Asia, and Western Europe accounted for the vast majority (85%)
of revenue losses as these regions are the predominant users of software. The
countries with the highest dollar losses due to software piracy were the United
States, Japan, Germany, China, France and Italy.  The total revenue loss for these countries was $6.8 billion or
62% of the worldwide losses in the year 2001.

Due to the risk of
substantial loss of revenue as a result of software piracy, software developers
have a need to protect their software against unauthorized use. However,
developers of low cost, shrink wrap software generally do not find the use of
sophisticated mechanisms to protect their software cost-effective. Most users
of sophisticated protection products today are software developers that sell
products at relatively higher price levels, typically in excess of $200 per unit.
These software developers range from smaller operations developing applications
for specific vertical markets, to large software developers creating
sophisticated enterprise-wide applications for distributed systems.

The need for software
protection has led to the development of several methods to prevent the illegal
use and duplication of software products. These methods include threats or
institution of legal proceedings, which is often costly and time-consuming, and
conditioning of product support on product registration.  Neither of these methods effectively
prevents illegal use or duplication of software products.  Many software-based protection solutions use
authorization codes to prevent unauthorized access to a program.  Authorization codes are unreliable and
inconvenient, due to the need to reauthorize or reassess the program for each
use and for each user on a network.

Token-Based Security Software Solutions

Our security token-based
products combine proprietary software and hardware components to prevent the
unauthorized use of computer software. The software component enables the
developer to integrate special software procedures into a protected program
either directly by accessing the software or through the creation of protected
versions of the software. These procedures check whether the appropriate token
is connected to the computers USB, parallel or serial port. Each software
developer is assigned a unique code which is embedded in an ASIC contained in
the token and which must be verified by the protected software before the
software can be activated.

During the development
cycle of the software program, the developer inserts special instructions into
the program, pursuant to which the program will automatically send a code, or
challenge, to the token at any point in the program chosen by the developer.
If the appropriate token is in place, it will automatically supply the proper
return code, or response, to the challenge, thereby enabling the protected
program to continue to operate. The challenge/response procedure is transparent
to the end-user if the program is being run with the appropriate token in
place. However, if there is no token in place, or the incorrect token is
installed, the program will not operate. 
Each developer determines how the program will react to the failure to
provide the appropriate response; for example, it can immediately cease
operating, activate only specific modules or switch to a demonstration mode.

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At the option of the
customer, our software protection systems can also be implemented automatically
- via the Envelope utility. This method of protection does not require the
software developer to access the source code, and it is therefore available for
use by software resellers. The Envelope utility creates a protected version of
the original program, which will only run if the appropriate token is connected
to the computer.

We believe that our
token-based software security product lines offer several advantages compared
to other software security devices, including other hardware-based devices
manufactured by our direct competitors. These advantages include:

| |  | Enhanced
  Security.The
  proprietary designs of both the hardware and software components of our
  systems provide enhanced security against unauthorized use of software. The
  ASIC in each token is custom-coded to prevent reverse engineering. In
  addition, the proprietary algorithms and anti-debugging features in our
  software are designed to ensure that the link between the token and the
  developers software is secure.                                                                             
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  | Transparency.Once connected, our
  hardware keys are transparent to the computer user and do not interfere with
  the operation or use of the computer or other peripheral products.                                                                                                                                                                                                                                                                                                                                      
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  | Compatibility.Our security products
  are available with interfaces for hundreds of languages and compilers under DOS, OS/2, Windows
  NT/2000, Windows 95/98/ME, Windows XP, Mac OS 8.6-9.x, Mac OS X, Linux, local
  area networks and other operating systems, as well as open systems such as
  Sun, HP and others. Our products offer solutions for all standard hardware
  platforms, including IBM PCs and PS/2s and their compatibles, Macintosh,
  Power Macintosh, Japanese NEC Computers and Unix workstations.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  | Ease
  of Use.  Our
  products are easy and convenient to use, and provide a low-cost solution to
  the problems of software piracy and illegal use. Our products can also be
  used to control access to different software modules and different software
  packages, and to limit usage to authorized users.                                                                                                                                                                                                           
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  | Multilevel
  licensing concepts. 
  Our products incorporate Full Authorization and Remote Update Systems
  that enable the user to protect multiple applications with a single key. They
  enable the user to specify the limitations of the use of each application,
  specific modules, the number of activations, the expiration date and the
  number of sites activated and update these limitations remotely in a secure
  manner.                                                                                 

We currently offer three
lines of token-based software security systems: HASP, Hardlock and MicroGuard.

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HASP Product Line

Our initial software
security product was HASP.  The standard
HASP model has undergone several upgrades and we now market it as HASP4.  This token offers the primary security features
that we develop, including an advanced ASIC chip with an on-chip encryption
engine, an Envelope tool for automatic protection and an Application
Programming Interface (API) for customized protection.

The following are our
principal HASP4 products that support Windows 3.x, 95/98/ME/2000/NT/XP, Linux,
Mac OS 8.6-9.x and Mac OS 10.x.:

HASP4 Standard: HASP4 Standard is a low
cost and high security solution. Using all the state-of-the-art techniques
included in the HASP system, HASP4 Standard offers an extremely secure, yet
surprisingly low-cost solution for software developers protection needs. HASP4
Standard is available in parallel and USB versions. The USB version is a true
cross platform solution that supports Windows, Linux and Mac operating systems.

HASP4 M1 and HASP4 M4:  HASP4 M1 and M4 combine the inherently high
level of encryption-based security with the flexibility of up to 496 bytes of
secured read/write memory and a unique ID number for every key. In-the-field
upgrading capabilities of HASP4 M1 and HASP4 M4 help software developers
implement their business strategy by enforcing sales models such as demo and
try-before-you-buy, for up to 112 applications  all in a single key. HASP4 M1
and M4 are available in parallel and USB versions. The USB versions are
cross-platform solutions that support Windows, Linux and Mac operating systems.

HASP4 Net: HASP4 Net is the most advanced
system available for protecting software running on networks. Just a single
HASP4 Net is required to activate a protected application from any of the
stations in a network. HASP4 Net supports TCP/IP, NetBios and IPX protocols.
HASP4 Net is available in parallel and USB cross-platform versions.

HASP4 Time: HASP4 Time is a HASP4 M4 key
that contains a real-time clock, especially designed for protecting
demonstration, try-before-you-buy and subscription versions of software
developers applications. Users can limit time execution of the application
according to dates, schedules or leasing periods. HASP4 Time is available in
parallel and USB cross-platform versions.

HASP4 PC-Card: HASP4 PC-Card is a PCMCIA
(Personal Computer Memory Card International Association) version of HASP4 M4.
Based on the PCMCIA Type-1 standard, it is specially suited for securing
software that runs on laptops and requires an unobtrusive protection solution.

AladdinCard: AladdinCard is a special
parallel card that lets software developers install parallel software
protection keys (by any manufacturer) safely inside the PC.

Hardlock Product Line

Following are our
principal Hardlock products, which support Windows 95/98/ME/2000/XP and Linux:

Hardlock Twin: The Hardlock Twin is an
ASIC-based token with variable response protection.  Its powerful encryption capability provides effective software
protection. The Hardlock Twin, built double-sided, plugs into a parallel or
serial port, offering flexibility. Hardlock Twin is available with 128 bytes of
memory (e.g. for management of multiple applications) and without memory.

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Hardlock E-Y-E: The Hardlock E-Y-E
contains the functionality of the Hardlock Twin, but is configured for use only
on the parallel port. Hardlock E-Y-E is available with or without 128 bytes of
memory.

Hardlock PCMCIA: The Hardlock PCMCIA
contains the same features as the Hardlock Twin, but is configured for the
PCMCIA/PCCard interface. Hardlock PCMCIA is a Type II PCCard and is available
with or without 128 bytes of memory.

Hardlock-On-Card: The Hardlock-On-Card has
the functionality of Hardlock Twin with the benefit of being an add-on board,
which can be plugged into ISA or PCI Microchannel buses. The Hardlock-On-Card
is available with or without 128 bytes of memory.

Hardlock Server: Hardlock Server is a
Hardlock key that protects software running on networks. Just a single Hardlock
Server is required to activate a protected application from any of the stations
in a network. Hardlock Server supports TCP/IP, NetBios and IPX protocols and is
available in parallel and USB versions.

Hardlock USB: The Hardlock USB contains
all the features of the Hardlock Eye, but is designed for the USB port instead
of the parallel port.

Hardlock SE: The Hardlock SE is a software
protection token for the serial port. 
The Hardlock SE offers a flexible cross-platform protection solution for
software vendors developing applications for UNIX workstations, as well as for
IBM PCs and their compatibles.

Microguard Product Line

The following are our
Microguard products:

Microguard Plus: Microguard Plus is a
microcontroller-based USB token designed for the Macintosh environment.  Microguard Plus is available with 128 bytes
of memory or with 624 bytes of memory. 
Microguard Plus is offered both in single user and in network models.

Microguard PC: Microguard PC is a parallel
port connection token for PCs.   It
contains 158 bytes of memory. 
Microguard PC is offered both in single user and in network models.

Internet Content Security Products

Todays anti-virus
software products are able to cope with all existing and known viruses and
virus technologies. The penetration and success of the Internet and its
innovative active content technologies such as Java, ActiveX and HTML scripts
have created a new type of Internet-specific threat collectively called
malicious content or Vandals. Unfortunately, existing anti-virus software
products are not designed to deal with these new threats. As opposed to
viruses, vandals are auto-executable applications that hit-and-run. They do
not linger in the users computer in order to replicate themselves.  Since vandals are usually unknown, standard
methods of scanning for known virus patterns do not work and there is a clear
need for a Proactive Content Security solution.

Signature-based
anti-virus software has been widely used since 1990 and today more than 90% of
corporate users have some sort of anti-virus protection deployed throughout
their organization. However, anti-virus software operates by scanning files and
trying to detect the signature of viruses from the database of known viruses
and relies heavily on the anti-virus vendor that must continue to update the
database in a timely manner in order to be protected against the new viruses.
In the Internet age, one cannot afford to be reactive and risk becoming the
first victim to be hit. Since dangerous vandals now travel at the speed of
light, there is absolutely no chance that we can analyze them in time and
update everybody before they can strike. Proactive solutions that provide
real-time protection against unknown potential threats by enforcing content
security policies at the gateway level are therefore critical.

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eSafe Family of Products

The eSafe solution is based on a
multi-tiered content security architecture, protecting the Enterprise on the
following levels:

| | The Internet Gateway - eSafe Gateway     
|- | -----------------------------------------
|  |                                          
| | The Corporate eMail server - eSafe Mail  
|  |                                          
| | The Integrated solution  eSafe Appliance

eSafe Gateway

eSafe Gateway is a
proactive content security and an anti-virus solution for Internet gateways,
eSafe Gateway manages Internet-borne information flow based on corporate
policies for content that is inappropriate, nonproductive or contains malicious
code such as vandals, viruses and worms. eSafe Gateway supports HTTP (web
browsing), FTP (file download), and POP3/SMTP (email) protocols and can be
configured to operate in any network with or without a firewall.

The following are eSafe
Gateways unique features:

| |  | NitroInspection
  patent-pending technology for fast on-line transparent inspection without
  overhead or delay on web browsing and file download traffic;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                           
| |  | Selective removal of cookies, JavaScript, VBScript,
  macros, and specific file types;                                                                    
| |   |                                                                                                                                                           
| |  | ICSA and Check Mark Certified anti-virus protection,
  with unique proactive Macro Terminator and Ghost
  Machine technologies;                           
| |   |                                                                                                                                                           
| |  | Scalable architecture with a built-in cluster for
  load sharing and fail-over;                                                                           
| |   |                                                                                                                                                           
| |  | Real-time protection from all types of malicious
  code including viruses, vandals, Trojans, ActiveX, Java, worms and scripts;
  and                      
| |   |                                                                                                                                                           
| |  | Eliminates malicious code embedded inside HTML web
  pages.                                                                                               

eSafe Mail:

eSafe Mail is a powerful proactive email
security and anti-virus solution. eSafe Mail protects Microsoft Exchange
servers, by scanning and cleaning both private and public mailboxes, as well as
standard email (SMTP) traffic to and from any mail servers. It manages email
traffic based on corporate policies for blocking and scanning dangerous
attachments, viruses, malicious scripts, spam, spoofed mail, and other hostile
content.

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The following are eSafe
Mails unique features:

| | Scalable architecture with a built-in content
  inspection load sharing;                                                                                                     
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                              
| | Scans and protects from all types of malicious code
  including viruses; vandals, Trojans, ActiveX, Java, worms and scripts                                                  
|  |                                                                                                                                                                              
| | ICSA (International Computer Security Association)
  and Check Mark Certified anti-virus protection, with unique proactive Macro
  Terminator and Ghost Machine technologies;
|  |                                                                                                                                                                              
| | Eliminates malicious code embedded inside email
  formatted as web-pages (HTML);                                                                                             
|  |                                                                                                                                                                              
| | Removes macros from untrusted Office documents;                                                                                                                              
|  |                                                                                                                                                                              
| | Multilayered anti-spam technology with zero false
  positives; and                                                                                                           
|  |                                                                                                                                                                              
| | Strong mail security with anti-relay, anti-spoof and
  anti-bomb features.                                                                                                   

eSafe Appliance

eSafe Appliance is the industrys first
content security and anti-virus gateway and mail inspection product that is compliant with OPSEC (Open Platform
for Security), the industrys open, multi-vendor security framework. It
operates as a dedicated server, pre-loaded with a hardened Linux OS and eSafe
Gateway or Mail content security applications. It fits easily into any existing
security infrastructure for an integrated, high-quality and cost effective
solution.

eSafes Unique technologies

MacroTerminator

By using pattern-matching
exact behavior analysis (heuristic algorithms), MacroTerminator is capable
of detecting, with a high degree of accuracy, macro viruses that are so new
that they have not yet been individually analyzed. Macro viruses are written in
a high-levelVBA (Visual Basic for Applications) language. High-level languages
are subject to heuristics, which enables high accuracy of hostile activity
detection, while maintaining an extremely low level of false positives (false
alarms). Macro
Terminator can recognize all known malicious macro families (such as
Melissa), and therefore can block the majority of new, yet unknown
variants/mutations of these families. Macro Terminator also has a high detection
rate of new, unknown malicious macros, which are not variants of known macro
families.

GhostMachine

Using this unique
technology, all members of the eSafe family of products have the ability to
increase detection rates for polymorphic viruses. Polymorphic viruses are
computer viruses that encrypt or cloak themselves while hiding in a
computers memory. These viruses need to decrypt themselves, or de-cloak in
order to attack their intended targets. Ghost Machine creates a simulated, virtual
machine in a computers memory, fooling polymorphic viruses into de-cloaking
themselves, at which point they become visible and therefore vulnerable to the eSafeanti-virus
scanning engine.

SmartScript
Filtering

eSafe is able to intelligently filter
content from scripts embedded in Web pages. These scripts can be programmed in
JavaScript, JScript, and/or VBScript.  eSafewill,
if configured to do so, automatically strip out only those scripts that contain
malicious commands (such as a command to access the hard drive of a local
system).

20

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Smart
Script filtering can recognize all known malicious script families and can
therefore block majority of new, yet unknown variants/mutations of these
families. It also has a high detection rate of new, unknown malicious scripts,
which are not variants of known script families.

XploitStopper

The virus and Internet
worm outbreaks in the last three years (Kaza, Nimda, Sircam, BugBear etc.) were
able to cause worldwide damage that is estimated at billions of US Dollars by
industry experts.  All those outbreaks
were caused because viruses and worms were able to exploit existing security
holes in various Internet applications (Outlook, IIS, etc.).  eSafesnew and innovative XploitStopper
technology is designed to look for known security holes that can be exploited
by malicious code and block it before the virus is able to enter the
organization.  This unique approach
minimizes the threat from new and unknown viruses and Internet worms.

NitroInspection

eSafe Gateway uses NitroInspection technology
to provide superior protection with little or no impact on network performance
and the end-user experience. This technology is built around a concept similar
to the stateful inspection technologies pioneered by Check Points Firewall-1
line of firewall products.

This method of scanning
files is far superior to the older proxy method. Alternative proxy-based
products require the content security device to receive the entire file and
scan or approve it before allowing any traffic to reach the requesting client.
This caused time-outs, user complaints, and bandwidth utilization problems.

Anti-Spam

Spam is growing rapidly. It is estimated that over 50% of today's business email is spam. Spam forces
Internet service providers to cope with increasing amounts of email traffic, and the bandwidth of businesses
is largely consumed by it, impacting resources and productivity. According to International Data
Corporation, spam is no longer just a nuisance; it is quickly becoming both a potential legal liability and a
major productivity drain for both corporate information technology departments and corporate users. Spam not
only drains worker productivity and consumes valuable information technology resources such as disk storage,
central processing unit cycles, and network bandwidth, but it can also expose the organization to legal
liability due to the offensive nature of some messages. We provide solutions to these problems by utilizing
multiple layers of anti-spam technology ranging from basic solutions that are built into our product to
offering our customers a sophisticated anti-spam service, which is based on our original equipment
manufacturer (OEM) relationship with Cobion, a German company that specialized in anti-spam and web filtering
technologies.

eToken Products

The
growth of both the Internet and mobile computing are continuously challenging
and redefining data security requirements. Corporations are caught between the
need for remote, convenient access and the need for protection from vandalism,
espionage and theft. Conventional password schemes alone are not effective in
protecting systems from outsiders or user negligence.

During
1999 and 2000, we released the eToken R2 and the eToken Pro, secure authentication devices which are the
size of a house key, and the accompanying software, eToken Enterprise.  eToken
ensures that only legitimate users gain access to network or PC resources by
requiring that the token be inserted into the computers USB port before
allowing the computer to operate. Our eToken technology offers users several
network and Internet security tools, including authentication, encryption and
secure certificate storage capabilities, all housed within the small, portable
eToken.  In addition, eToken provides
user flexibility in deployment through advanced smartcard technology.  eTokens versatile architecture  enables organizations  to 
use  both existing authentication
systems  or introduce new ones  based 
on  advanced  technology,  while maintaining a similar end-user experience. Support for
standard security interfaces, coupled with the ability to cache user passwords,
enables the eToken solution to be operated with almost any authentication
system.

Our
eToken technology allows for concurrent storage of multiple private keys,
passwords and digital certificates for use in a wide variety of applications.
eToken can be used as an authentication device for e-banking, virtual private
networks, extranets and wide area networks and as an enabler for e-Commerce.
eToken serves as an encryption device that enables companies to verify the
identity of individuals who request access to protected content or applications
provided over their networks or websites. 
eToken can be used to protect sensitive data and resources by performing
file encryption and access control functions. eToken can also be used in
conjunction with third-party software to digitally sign and/or encrypt
electronic messages so that they cannot be modified or intercepted. eToken does
not require an additional reader to effectively control any user within the
network.  eToken links to USB ports in
PCs and laptops of all major manufacturers.

21

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International
Data Corporation predicts  that  USB 
tokens  and  smartcards will become interoperable
because  USB  tokens  also  have 
PKI  (Public Key
Infrastructure) and  digital-certificate capability.  As the technology develops, USB keys will be
able to provide  an  integrated 
solution  that  could 
only  previously  have been provided  through  separate  authentication  devices.  We are currently
developing expanded functionality for the eToken in order to simplify password
management by allowing the eToken to store multiple credentials, such as
digital certificates to simple passwords, which can easily be retrieved from
the token without user interaction.

Internet
Software Distribution Products

Privilege Software Commerce Platform

We believe that the
Privilege Software Commerce Platform (SCP) is one of the most comprehensive and
flexible infrastructure solutions for managing, selling, and distributing
software over the Internet.  Through
digital delivery, software is immediately and widely accessible, always in
stock, and up to date.  In addition,
digital delivery of software saves printing, packaging and shipping expenses,
inventory and warehousing costs, while ensuring the protection of our
customers intellectual property.

Privilege SCP is composed
of three principle components:

The Builders a suite of tools (some
standard and some optional) that prepare software for electronic distribution,
add mechanisms for protecting intellectual property, and set usage rights for
software after it is installed.

The Commerce Server  the back-end
component that manages and warehouses the digital inventory, and ensures
secure, automated, and reliable fulfillment of software product and license
orders.

The Storefront Engine  the front-end
component that provides an access mechanism from a merchants on-line
storefront to software warehoused on Commerce Servers, in order to sell and
distribute software products to consumers.

The architecture of Privilege
SCP allows for the Storefront Engine to be operated either by a
software publisher for direct sales or by an on-line reseller/retailer for
channel sales.  The Commerce Server is
operated by either a software publisher or a software distributor.  A Storefront Engine can connect to multiple
Commerce Servers and a Commerce Server can connect to both multiple Storefront
Engines and other Commerce Servers, creating a virtual software supply chain.

Privilege SCP is tailored to the
customers requirements based upon the core technology and the latest product
release. In general, Privilege SCP enables software publishers,
distributors, and retailers to:

| | sell and distribute software products via the
  Internet through multiple channel partners, each with individual terms,
  without having to maintain multiple electronic distribution platforms;
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

22

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| | manage the full product lifecycle, from product
  development through end-customer usage rights; and
|- | ----------------------------------------------------------------------------------------------------
|  |                                                                                                     
| | trial-enable software, including electronically
  enabled try-before-you-buy models.                

We recently released Privilege
SCP 5.0, which supports software delivery to and protection on the
Windows XP or Macintosh OS X platforms.

Our business is not
dependent on patents or licenses.

Marketing and Promotion

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

| | press releases;                                                                          
|- | -----------------------------------------------------------------------------------------
|  |                                                                                          
| | direct mail campaigns;                                                                   
|  |                                                                                          
| | email sponsorships and campaigns;                                                        
|  |                                                                                          
| | publication of technical and educational articles in
  industry journals;                
|  |                                                                                          
| | participation in industry trade shows;                                                   
|  |                                                                                          
| | organization of and participation in
  product/technology conferences and seminars;      
|  |                                                                                          
| | competitive analysis;                                                                    
|  |                                                                                          
| | sales training;                                                                          
|  |                                                                                          
| | advertising in trade magazines;                                                          
|  |                                                                                          
| | Internet promotion;                                                                      
|  |                                                                                          
| | Internet advertising;                                                                    
|  |                                                                                          
| | development and distribution of literature about our
  company; and                      
|  |                                                                                          
| | maintenance of our web site distribution of free
  samples of Internet Security products.

We sell our products
directly, including through our website, through subsidiaries, value-added resellers,
original equipment manufacturers and through independent distributors in over
50 countries worldwide.  We believe that
our success and ability to market our products will depend, to a significant
degree, on our subsidiaries and independent distributors and resellers.  In the years ended December 31, 2002, 2001,
and 2000, approximately 22.6%, 19.4% and 18.5%, respectively, of our
consolidated revenues were generated from sales to our independent
distributors. During these periods, no single distributor accounted for more
than 10% of our sales.We
generally have short-term written agreements with our distributors and
resellers, all of which are non-exclusive. 
If we lose or decrease the volume of sales to some of our distributors
and resellers, our total sales could materially decrease.

23

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In 2001, we entered into
distribution agreements with leading distributors in Europe
(Articon-Integralis) and the United States (Westcon Group).  We have continued our relationship with
these distributors in 2002 and into 2003. 
The Alasso unit of Articon-Integralis was recently sold by Articon-Integralis to InTechnology plc and we
have maintained our relationship with Alasso. 
We have also entered into an agreement with Digital River, Inc.  which allows us to offer our products and
services to their customers at our standard rates. We intend to continue to
target resellers and system integrators that focus on providing security
solutions to enterprises. In addition, we have launched Aladdin Security
Alliance, our solution partner program. In this program we present joint
solutions that are offered to the market by both our partners and our
distribution channels. These distribution channels include vendors in areas
such as PKI, VPN (Virtual Private Network), Access Control, Web Access, PC
Security and more. However, there can be no assurance that we will successfully
establish new distribution arrangements, or that any of our distributors will
devote sufficient resources to market and distribute our products effectively.
In addition, since we rely on distributors, we have an indirect relationship
with consumers of our products in many markets. As a result, we may not learn
of customers satisfaction or dissatisfaction with our products and may not
respond quickly to specific market needs, which may negatively affect our
results of operations.

Maintenance and Support

We believe that providing
a high level of customer service and support is essential to our success.
Outside of Israel, the first-line of support is provided by our subsidiaries
and distributors, while we provide the second-line of support.

Software Security Products

We, together with our
subsidiaries and distributors, provide maintenance and support services for our
software security products free of charge. 
These maintenance and support services include a hot-line telephone
number that can be used by customers during business hours to assist them in
solving problems.  We also support
customer inquiries via fax and e-mail, and provide additional technical
information on our Internet home page. In addition, software developers who
have purchased our token-based software security products can download software
updates from our FTP (File Transfer Protocol) Internet site free of charge.

Internet Security Products

We generally provide
maintenance and support services for our Internet security products during the
first 12 months following the installation of the product, depending on the
terms of each particular sale and the warranty that we provide.  These maintenance and support services
include a hot-line telephone number during business hours, fax and e-mail
support and product updates.  After the
expiration of the warranty period, each of our Internet security customers is
offered a long-term maintenance agreement with us, or with one of our
subsidiaries or distributors, as the case may be. These maintenance agreements
include the same services provided during the warranty period. The maintenance
agreements generally have one-year terms and in some cases are automatically
renewable.

eToken

We generally provide a
12-month manufacturers warranty on our eToken hardware product.  During this warranty period, we replace any
eToken that fails as a result of a recognized manufacturers defect with a like
replacement. We provide eToken users with technical support via phone, fax and
e-mail from our Tel Aviv headquarters and through all our subsidiaries.  We also offer a comprehensive Web site
containing technical support information on eToken.

24

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Privilege

The license agreement for
Privilege SCP includes a maintenance and support component.  The standard maintenance and support package
provides free access to product updates along with access to our support center
in Portland, Oregon during set hours. 
The support center is accessible to our customers via e-mail or
telephone.  For those customers who
require round the clock support, an enhanced support package is available.  This enhanced package provides 24 hour
coverage with maximum response times.

Managed Privilege is our
managed service which hosts the software publishers store. Our Managed
Privilege customers receive up to three levels of support.  The first level includes free access to
product updates along with access to our support center.  The second level includes various management
and administrative options to ensure Web site availability, prepare products
for distribution, and track the success of product promotions.  The third level can include end-user support
for download problems and/or product returns where calls are answered under our
customers name.

Government Controls

As a result of our
research and development activities in Israel, we are required to obtain export
permission from the Israeli government before exporting certain technologies.We
have recently received governmental permission to manufacture and export the
eToken R2, and eToken PRO. We believe that all of the other products that
we currently market do not require such approval.  However, we may require approval to sell certain products
currently under development that include encryption technology as well as
future versions of eToken.  We cannot
guarantee that we will be successful in obtaining approvals we may apply for in
the future, or that we will obtain these approvals in a timely manner.

Sales of our products in
Europe are subject to various regulations, including directives adopted by the
European Community. These directives provide, among other things, that we
comply with International Standard ISO 9000 (European Standard EN 29000)
entitled Model for Quality Assurance in Design, Development, Production,
Installation and Servicing.  In 1997,
we received ISO 9002 certification, which is valid until October 2003 and we
recently received ISO 9001-2000 certification, which is valid until March 31,
2006. We have consistently passed the semiannual ISO audit.

In addition, we receive
certain tax benefits and reduced tax rates from the government of Israel (See
Item 10: Additional Information - Taxation. and
Note 13d to our Financial Statements). 
The entitlement to these benefits is conditional upon our fulfillment of
the conditions stipulated by the law, regulations published thereunder and the
instruments of approval for the specific investments including investments from
equity.  In the event of a failure to
comply with these conditions, the benefits could be canceled and we would be
required to refund the amount of benefits, in whole or in part, with the
addition of linkage difference and interest.

Customers

We sell our software
security products primarily to software developers and distributors.  No one customer accounted for more than 10%
of our net sales in 2002, 2001 and 2000. 
The following is a breakdown of our sales by geographic market:

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|                                  |  |  | Percentage of sales in,        | 
|--------------------------------- |  |  | ------------------------------ | 
|Year
  
  ending
  December
  31, |  |  | Europe
  (excluding
  Germany) | 
|                                  |  |  |                                | 
|2002*                             |  |  | 26.8%                          | 
|2001*                             |  |  | 26.9%                          | 
|2000                              |  |  | 25.1%                          | 

*Includes customers for
product lines acquired in the Preview acquisition.

Manufacturing,
Testing and Suppliers

Our manufacturing, system
integration and testing operations for our HASP, Hardlock, Microguard and
eToken products are located in Kiryat Gat, Israel. Certain components of our
Hardlock line of products are manufactured on a sub-contracting basis in
Germany.

Our HASP and Hardlock manufacturing
operations consist primarily of assembling finished goods from components.  We seek to monitor quality with respect to
each stage of the production process, including the selection of component
suppliers, the assembly of finished products and final testing, packaging and
shipping. We use an automated surface-mounted technology to produce
substantially all of our HASP, Hardlock and eToken products. We perform testing
and quality assurance procedures with respect to the components and
subassemblies, which are incorporated into our final products and with respect
to the final products ourselves. We believe that our in-house manufacturing
capabilities with respect to our HASP, Hardlock and eToken product lines have
been instrumental in achieving a high degree of reliability for our products.

We generally fill our
typical order for products within several hours to several days after receipt
of a firm purchase order. Due to the nature of our sales and marketing efforts
and our close contact with our customer prior to the receipt of a purchase
order, we can often plan production and order the components necessary to
enable us to deliver products in a relatively short time after our receipt of a
purchase order.

Most of the parts and
components that we use to manufacture and assemble our products are available
from several sources, although we do purchase certain components from single
source suppliers and prices may fluctuate due to changes in the market.  Currently, we buy most of our raw materials
from Philips, Elmos, Fairchild, Seiko, Infinion, Cypress and Samsung. To ensure
the supply and price of components which we purchase from single source
suppliers, these components are purchased under long term contracts with our
suppliers that ensure supply and price for periods of a year and more. We also
hold safety stocks of such components to ensure steady supply in the event our
supplier experiences difficulties or delays. Furthermore, we split the storage
of critical components amongst different locations to ensure that there is
always a readily available supply of critical components.

Organizational Structure

We have three wholly
owned subsidiaries: Aladdin Knowledge Systems, Inc., a United States subsidiary
incorporated in the state of New York; Aladdin Japan & Co. Inc., a Japanese
subsidiary; and Aladdin Western Europe Ltd. (formerly known as Aladdin Knowledge Systems UK
Ltd.), a United Kingdom subsidiary incorporated in England and Wales. These
subsidiaries are all involved in distribution, support and management for our
products.

26

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In addition we have a
wholly owned holding company, Hafalad BV, which is incorporated in
Holland.  Through Hafalad we wholly own
Aladdin Western Europe BV (formerly known as Aladdin Knowledge Systems BV),
Aladdin Western Europe (Aladdin France S.A.R.L.) (formerly known as Aladdin
France S.A), Aladdin Knowledge Systems Deutschland GmbH and Aladdin Knowledge
Systems Verwaltung GmbH.  Aladdin
Knowledge Systems Deutschland GmbH and Aladdin Knowledge Systems Verwaltung
GmbH are both incorporated in Germany and are the sole partners in Aladdin
Knowledge Systems GmbH & Co. KG. Aladdin Western Europe BV is incorporated
in Holland and Aladdin Western Europe (Aladdin France S.A.R.L.)  is incorporated in France. We are currently
in the process of reorganizing the management of activities in France, the
Netherlands and the United Kingdom, under the single management of Aladdin
Western Europe Ltd. In addition to engaging in distribution, support and
management, our German subsidiaries and Portland, Oregon office provide
research and development services.

Property, Plants and Equipment

Our executive, research
and development offices and certain of our production facilities are located in
Tel Aviv, Israel. We currently lease a total of approximately 2,300 square
meters of space from an unaffiliated entity, at an aggregate base monthly rent
of approximately $15,000, which lease expires in 2006 with an option for one
additional year.

Most of our production
facilities are located in Kiryat Gat, Israel. 
We currently lease a total of approximately 976 square meters in Kiryat
Gat, which lease expires on September 30, 2005, for an aggregate monthly
rent of approximately $6,300.In
addition, we lease approximately 725 square meters in Haifa, Israel, where our
Internet security research and development activities are headquartered, at a
monthly rent of approximately $7,200. 
Our lease in Haifa expires on February 29, 2004.

We lease space for our
operations in the United States, Germany, United Kingdom, Japan, the
Netherlands and France.  Aggregate
monthly lease payments under these leases are approximately $67,000.  Our leases in these locations expire between
2004 to 2007.

Our aggregate lease
expenses (including motor vehicles) for the years 2002, 2001 and 2000 were $2,514,000, $2,423,000 and $1,375,000,
respectively.   We believe that our
facilities are adequate for our current needs. 
In the event that additional facilities are required, we believe that we
could obtain such additional facilities at commercially reasonable prices.

Item
5.               Operating
and Financial Review and Prospects

Critical
Accounting Policies

We have identified the
following policies as critical to the understanding of our financial
statements. Our consolidated financial statements are prepared in accordance
with accounting principles generally accepted in the United States, or GAAP.
The preparation of our financial statements requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities, based upon information
available at the time that they are made, 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.

27

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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.

Revenue recognition. Our products are
generally a bundled hardware and software solution that are delivered together.
Revenues from products are recognized in accordance with Staff Accounting
Bulletin No. 101 Revenue Recognition in Financial Statements (SAB No. 101)
when the following criteria are met: persuasive evidence of an arrangement
exists, delivery of the product has occurred, the fee is fixed or determinable,
collectibility is probable and we do not have any obligation to customers after
the date in which products are delivered.

We generate revenues from
licensing the right to use our software products directly to end-users and
indirectly through resellers (both of whom are considered end users), from the
sale of products, maintenance and updates.

Revenues from software
license agreements are recognized, in accordance with Statement Of Position
97-2, Software Revenue Recognition (SOP 97-2), as amended, upon delivery of
the software, when collectibility is probable, the license fee is fixed or
determinable, vendor-specific objective evidence (VSOE) of fair value exists
to allocate the appropriate fee to undelivered elements of the arrangement,
persuasive evidence of an arrangement exists and no further significant
obligation remains.

Where software
arrangements involve multiple elements, revenues are allocated to each element
based on VSOE of the relative fair values of each element in the arrangement in
accordance with the residual method prescribed by SOP 98-9 Modification of
SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions.
Our VSOE which we use to allocate the sales price to updates and maintenance is
based on the price charged when these elements are sold separately. License
revenues are recorded based on the residual method. Under the residual method,
revenues are recognized for the delivered elements when (1) there is
vendor-specific objective evidence of the fair values of all the undelivered
elements and (2) all revenue recognition criteria of SOP 97-2, as amended, are
satisfied. Under the residual method any discount in the arrangement is
allocated to the delivered element.

Revenues from maintenance
and updates are recognized over the term of the agreement.

Deferred
revenues include unearned amounts received under maintenance contracts, and
amounts billed to customers but not yet recognized as revenues.

Accounts Receivable.We are required
to perform ongoing credit evaluations of our trade receivables. We maintain an
allowance for doubtful accounts. Management exercises its 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 and current economic trends.

Inventories. Inventories are stated at
the lower of cost or market value. Cost is determined by the 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.

28

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Deferred tax. We record a valuation
allowance to reduce our deferred tax assets to the amount that we believe is
likely to be realized. In assessing the need for a valuation allowance, we
consider all positive and negative evidence, including reversals of existing
deferred tax liabilities, estimated future taxable income, prudent and feasible
tax planning strategies, and recent financial performance. Due to the history
of losses in our subsidiaries (except Germany) and the estimation that it is
more likely than not that the net deferred tax assets related to our
subsidiaries loss carry-forwards will not be utilized, we concluded that a
full valuation allowance of $9.7 million against our net deferred tax
assets related to our subsidiaries loss carry-forwards, at December 31,
2002 was appropriate. If, in the future, we believe that a deferred tax asset
will be realized, for which we currently have a valuation allowance, we will be
required to reverse the valuation allowance, which could result in an income
tax benefit in the period of such determination.

Goodwill. Under Statement of Financial
Accounting Standard No.142, Goodwill and Other Intangible Assets (SFAS No,
142), goodwill acquired in a business combination which closes on or after
July 1, 2001 is deemed to have indefinite life and will not be amortized. SFAS
No.142 requires goodwill to be tested for impairment on adoption and at least
annually thereafter or between annual tests in certain circumstances, and
written down when impaired, rather than being amortized as previous accounting
standards required. Goodwill is tested for impairment by comparing the fair
value of the reporting unit with its carrying value. Fair value is determined
using market multiples and comparative analysis. Significant estimates used in
the methodologies include estimates of market multiples for the reportable
unit. We have performed impairment tests on our goodwill and as of December 31,
2002, no impairment losses have been identified.

Selected
Financial Data

Our consolidated
financial statements have been prepared in accordance with accounting
principles generally accepted in the United States (GAAP).

We derived the selected
consolidated statements of operations data set forth below for the years ended
in December 31, 2000, 2001 and 2002, and the selected consolidated balance
sheet data as of December 31, 2001 and 2002, from our audited consolidated
financial statements, which are included elsewhere in this annual report. We
derived the consolidated statements of operations data for the years ended
December 31, 1998 and 1999 and the selected consolidated balance sheet data as
of December 31, 1998, 1999 and 2000 from audited consolidated financial
statements that are not included in this annual report. Please see Note 2 to
our Consolidated Financial Statements for a discussion of our significant
accounting policies.

29

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The tables that follow
present portions of our financial statements and are not complete. The
following selected financial data should be read in conjunction with our
consolidated financial statements and notes thereto, included in this annual
report. Historical results are not necessarily indicative of any results to be
expected in any future period.

|                           |                                                                                      |  | December 31,                                         |       
|-------------------------- | ------------------------------------------------------------------------------------ |  | ---------------------------------------------------- | ------
|                           |                                                                                      |  | 2002                                                 |       
|                           |                                                                                      |  |                                                      |       
|                           |                                                                                      |  | (U.S. dollars in thousands, except
  per share data) |       
|Statement
  of Income Data |                                                                                      |  |                                                      |       
|Revenues:                  |                                                                                      |  |                                                      |       
|                           | Product
  sales                                                                      |  | $                                                    | 39,552
|                           | Software
  sales and other                                                           |  |                                                      | 9,968 
|                           |                                                                                      |  |                                                      |       
|                           | Total                                                                                |  |                                                      | 49,520
|                           | Cost of revenues:                                                                    |  |                                                      |       
|                           | Product sales                                                                        |  |                                                      | 9,111 
|                           | Software sales and other                                                             |  |                                                      | 1,127 
|                           |                                                                                      |  |                                                      |       
|                           | Total                                                                                |  |                                                      | 10,238
|                           | Gross profit                                                                         |  |                                                      | 39,282
|                           | Operating expenses:                                                                  |  |                                                      |       
|                           | Research and development                                                             |  |                                                      | 13,833
|                           | Selling and marketing                                                                |  |                                                      | 21,990
|                           | General and administrative                                                           |  |                                                      | 5,659 
|                           | Impairment of intangibles assets                                                     |  |                                                      |      
|                           | Other special charges                                                                |  |                                                      |      
|                           |                                                                                      |  |                                                      |       
|                           | Total operating expenses                                                             |  |                                                      | 41,482
|                           | Operating income (loss)                                                              |  |                                                      | (2,200
|                           | Financial income (expenses), net                                                     |  |                                                      | 491   
|                           | Other income (expenses), net                                                         |  |                                                      | (932  
|                           |                                                                                      |  |                                                      |       
|                           | Income (loss) before taxes                                                           |  |                                                      | (2,641
|                           | Taxes on income                                                                      |  |                                                      | 2,738 
|                           |                                                                                      |  |                                                      |       
|                           | Income (loss) before equity in losses of an
  affiliate                              |  |                                                      | (5,379
|                           | Equity in losses of an affiliate                                                     |  |                                                      | (1,257
|                           |                                                                                      |  |                                                      |       
|                           | Net income (loss)                                                                    |  |                                                      | (6,636
|                           | Net earnings (loss) per share:                                                       |  |                                                      |       
|                           | Basic                                                                                |  | $                                                    | (0.59 
|                           | Diluted                                                                              |  | $                                                    | (0.59 
|                           | Weighted average number of shares used in computing
  net earnings (loss) per share: |  |                                                      |       
|                           | Basic                                                                                |  |                                                      | 11,253
|                           | Diluted                                                                              |  |                                                      | 11,253
|                           |                                                                                      |  |                                                      |       

| |                                                                                 |  | December 31,              |       
| | ------------------------------------------------------------------------------- |  | ------------------------- | ------
| |                                                                                 |  | 2002                      |       
| |                                                                                 |  |                           |       
| |                                                                                 |  | U.S. dollars in thousands |       
| | Balance
  Sheet Data:                                                           |  |                           |       
| | Cash and cash equivalents, short term bank deposits
  and marketable securities |  | $                         | 15,095
| | Working capital                                                                 |  |                           | 22,664
| | Total assets                                                                    |  |                           | 48,539
| | Total liabilities                                                               |  |                           | 12,212
| | Shareholders equity                                                            |  |                           | 36,327

30

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Operating Results

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

|                          |                                                          |  | 2002    |         |  | 2001    |         |  | 2000  |       
|------------------------- | -------------------------------------------------------- |  | ------- | ------- |  | ------- | ------- |  | ----- | ------
|                          |                                                          |  |         |         |  |         |         |  |       |       
|Revenues                  |                                                          |  | 100%    |         |  | 100.%   |         |  | 100.% |       
|                          | Cost of revenues                                         |  |         | 20.67   |  |         | 20.00   |  |       | 24.00 
|                          | Gross profit                                             |  |         | 79.33   |  |         | 80.00   |  |       | 76.00 
|                          | Research and development                                 |  |         | 27.93   |  |         | 26.70   |  |       | 22.08 
|                          | Selling and marketing                                    |  |         | 44.41   |  |         | 48.21   |  |       | 46.80 
|General  & administrative |                                                          |  | 11.43   |         |  | 16.04   |         |  | 15.01 |       
|                          | -Impairmant of intangibles assets                        |  |         |        |  |         | 11.18   |  |       |      
|                          | Operating income (loss)                                  |  |         | (4.44)  |  |         | (22.12) |  |       | (7.89)
|                          | Financial income (expenses), net                         |  |         | 1.00    |  |         | (0.88)  |  |       | 3.20  
|                          | Other income (expenses), net                             |  |         | (1.88)  |  |         | (7.23)  |  |       | 12.36 
|                          | Income (loss) before taxes                               |  |         | (5.33)  |  |         | (30.24) |  |       | 7.67  
|                          | Taxes on income                                          |  |         | 5.53    |  |         | (0.74)  |  |       | 3.70  
|                          | Income (loss) before equity in losses  of an
  affiliate |  |         | (10.86) |  |         | (29.49) |  |       | 3.98  
|                          | Equity in losses of an affiliate                         |  |         | 2.54    |  |         | 2.51    |  |       | 0.73  
|Net income (loss)         |                                                          |  | (13.40) |         |  | (32.00) |         |  | 3.25  |       

Year Ended December 31, 2002 Compared to Year Ended December
31, 2001

Revenues.Revenues increased
approximately 6.2% to $49.52 million during 2002 compared with revenues of
$46.6 million during 2001. This increase was primarily a result of increases in
sales of Privilege products (following the Preview asset acquisition) and in
sales of our eToken products due to increased market penetration.

Cost of revenues.Cost of revenues
primarily include the manufacturing cost of the hardware and overhead related
to manufacturing activity. Cost of revenues was approximately $10.2 million
during 2002 compared with $9.3 million in 2001.  This slight increase was due to our producing a slightly
different mix of products in 2002. 
Since the cost of revenues is different for all of the products we
produce, a change in the mix of products we produce in any given year will
subsequently change our cost of revenues in that year. Cost of revenues, as a
percentage of total revenues, increased to 20.7% in 2002 as compared to 20% in
2001.

Research and development expenses. Research and development expenses consist
primarily of compensation and related costs of employees engaged in on-going
research and development activities, costs of subcontractors and related
expenses. Research and development expenditures increased 11.2% to
approximately $13.8 million during 2002, as compared to $12.4 million during
2001.  As a percentage of revenues,
research and development expenses, increased to 27.9% in 2002 from 26.7% during
2001.  This increase was due to an
increase in compensation expenses resulting from the hiring of new research and
development personnel, primarily for the development of eToken and for our new
research and development center that we opened in connection with the Preview
acquisition. We expect to expand our research and development efforts, and we
are currently developing new products that incorporate both technology
presently used in our products and technology that we are developing for new
applications.

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Selling and Marketing expenses.
Selling and marketing expenses consist primarily of compensation for sales and
marketing personal, exhibitions, travel and related expenses.  Selling and marketing expenses slightly
decreased to approximately $22 million during 2002 as compared to $22.5 million
during 2001.  As a percentage of revenues,
selling and marketing expenses, decreased to 44.4% in 2002 from 48.2% during
2001.  This level of stability of the
selling and marketing expenses was a result of the continuation of the
implementation of our marketing plan with respect to the eSafe, eToken and
Privilege product lines.

General and administrative expenses.General
and administrative expenses consist primarily of compensation for finance and
human resources, allowance for bad debt, good will amortization as well as
professional service expenses. General and administrative expenses decreased to
approximately $5.7 million during 2002 as compared to $7.5 million during
2001.  As a percentage of revenues,
general and administrative expenses, decreased to 11.4% in 2002 from 16% during
2001.  This decrease in general and
administrative expenses resulted primarily from the fact that goodwill
amortization in 2002 decreased by $1.96 million as compared with 2001. This
decrease in goodwill amortization was due to 
our adoption of SFAS No. 142, Goodwill and Other Intangible
Assets, whereby  we ceased amortizing
goodwill and performed an annual impairment test in accordance with SFAS 142
(see Note 2 to our consolidated financial statements).

Restructuring charges.As a result of
the downturn in the global economic conditions, the decline in overall business
levels and the related impact on our operations, we implemented during 2002 a
worldwide restructuring and cost reduction plan, including at the level of our
subsidiaries. In 2002 we, together with our subsidiaries, recorded expenses of
approximately $1.12 million, associated primarily with a reduction in work
force and general reduction in all operating expenses.

Impairment of intangible assets.Impairment
of intangible assets in 2001 consisted of the impairment of $5.2 million of the
Eliashim goodwill. There was no impairment of intangible assets in 2002.

Financial income (expenses), net.
Financial income (expense) consists primarily of interest derived from cash and
cash equivalents and marketable debt securities, net of bank charges, gain
(loss) from exchange rates difference and loss on decreases in value of the
Companys investment in equity securities. Financial income in 2002 was
$491,000 compared with financial expenses of $(410,000) in 2001. This increase
was primarily generated by foreign currency gains, due to the increase in
exchange rate of Euros and Japanese Yen to the dollar and the weakening of the
New Israeli Shekel to the dollar, partially offset by continued decrease of
interest derived from cash and cash equivalents.

Other expense, net.Other expenses
net, were approximately $(932,000) in 2002 compared with $(3.4) million in
2001. Other expenses in 2002 were primarily generated by the write off of our
investment in Tamir Fishman Ventures II. Other expenses in 2001 were primarily
generated by the write off of our investment in FAST Multimedia Inc. (See Item
7: Related Party Transactions).

Taxes on income.Taxes on income were
approximately $2.7 million in 2002 compared to approximately $(347,000) in
2001. Taxes on income in 2002 were primarily due to an income tax provision
from ongoing operations of approximately $200,000 and due to the increase of
the valuation allowance for deferred tax assets of approximately $2.5 million.  We believe that it is more likely than not
that the deferred tax regarding carry-forward losses will not be utilized.
Taxes on income in 2001 were primarily due to an income tax provision from
ongoing operations of approximately $146,000 and deferred tax income of
approximately $(493,000) regarding carry-forward losses.

32

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Year Ended December 31, 2001 Compared to Year Ended December
31, 2000

Revenues.Revenues increased
approximately 5% to $46.6 million during 2001 compared with revenues of $44.3
million during 2000. This increase was mainly a result of increases in sales of
Privilege products (following the Preview asset acquisition) and in sales of
our eToken products due to increased market penetration.

Cost of revenues.Cost of revenues
primarily include the manufacturing cost of the hardware and overhead related
to manufacturing activity. Cost of revenues was approximately $9.3 million
during 2001 compared with $10.6 million in 2000.  Cost of revenues, as a percentage of total revenues, decreased to
20% in 2001 as compared to 24% in 2000. 
This decrease was due to our producing a slightly different mix of
products in 2001.  Since the cost of
revenues is different for all of the products we produce, a change in the mix
of products we produce in any given year will subsequently change our cost of
revenues in that year.   During the year
2000, cost of revenues included, among other things, royalties that we paid to
Mr. Matthias Zahn, the former principal shareholder of FAST and a former
director of our company, on revenues of Hardlock products in certain countries.These
royalties totaled approximately $447,000 in 2000. The payment of the royalties
ceased in 2001 following an agreement with Mr. Zahn.

Research and development expenses. Research and development expenses consist
primarily of compensation and related costs of employees engaged in on going
research and development activities, costs of subcontractors and related
expenses. Research and development expenditures increased 27.1% to
approximately $12.4 million during 2001, as compared to $9.8 million during
2000.  This increase was due to an
increase in compensation expenses resulting from the hiring of new research and
development personnel, primarily for the development of eToken and for our new
research and development center that we opened in connection with the Preview
acquisition.

Selling and Marketing expenses.
Selling and marketing expenses consist primarily of compensation for sales and
marketing personal, exhibitions, travel and related expenses.  Selling and marketing expenses increased to
approximately $22.5 million during 2001 as compared to $20.8 million during
2000.  As a percentage of revenues,
selling and marketing expenses, increased to 48.2% in 2001 from 46.8% during
2000.  This increase was a result of the
implementation of our marketing plan with respect to the eSafe, eToken and
Privilege product lines.

General and administrative expenses.General
and administrative expenses consist primarily of compensation for finance,
human resources and allowance for bad debt as well as professional service
expenses. General and administrative expenses increased to approximately $7.5
million during 2001 as compared to $6.7 million during 2000.  As a percentage of revenues, general and
administrative expenses, increased to 16% in 2001 from 15% during 2000.  The general and administrative expenses have
been kept stable during those years.

Impairment of intangible assets.Impairment
of intangible assets in 2001 consisted of the impairment of $5.2 million of the
Eliashim goodwill. There was no impairment of intangible assets in 2000.

Financial income, net. Financial
income (expenses) consists primarily of interest derived from cash and cash
equivalents and marketable debt securities, net of bank charges and loss on
decrease in value of the Companys investment in equity securities. Financial
expenses in 2001 were $(410,000) compared with financial income of $1.4 million
in 2000. The decrease in the financial income was primarily due to lower
interest rates on cash and cash equivalents, a reduction in cash reserves and
declines in the value of the Companys investment in equity securities.

33

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Other income (expenses), net.Other
income (expenses) net, was approximately $(3.4) million in 2001 compared with
$5.5 million in 2000. Other income in 2001 was primarily generated by the write
off of our investment in FAST Multimedia Inc. (See Item 8: Related Party
Transactions). Other income in 2000 was primarily generated by the sale of
384,500 shares of Wave Systems Corp. Class A common stock for $4,641,225.

Taxes on income.Taxes on income were
approximately $(347,000) in 2001compared to approximately $1.6 million in 2000.
Taxes on income in 2001 were primarily due to an income tax provision from
ongoing operations of approximately $146,000, and deferred tax income of
approximately $(493,000) from carry-forward losses. Taxes on income in 2000
were primarily due to taxes on capital gains from the sale of shares of Wave
Class A common stock, which were taxed at the rate of 36% as opposed to our
income from operations which is taxed at an effective rate of 8% as a result of
our Approved Enterprise status.

Liquidity and Capital Resources

Since
our inception, our operations have been funded through capital contributions,
cash flow from operations and capital gains from sales of marketable
securities.  Our business is not capital
intensive.  Currently, our commitments
for capital expenditures are insignificant as we lease all of our premises.

As
of December 31, 2002, we had cash and cash equivalents and marketable
securities aggregating approximately $15.1 million.  Our marketable securities, as of December 31, 2002, amounted to
approximately $860,000. Unrealized holding gains from available-for-sale
securities (which are presented as part of shareholders equity until realized)
amounted to approximately $(67,000) thousand as of December 31, 2002.  At December 31, 2002, we had equity
investments in Comsec Information Security Ltd. and Tamir Fishman Ventures II
Ltd., Israeli companies publicly traded on the Tel Aviv Stock Exchange (TASE).

Our
operating activities provided cash in the amount of $4.2 million in 2002
primarily due to a decrease in other accounts
receivable and prepaid expenses, a decrease in inventories, a decrease in
deferred income tax, equity in
losses of an affiliate, impairment of investments and depreciation and
amortization which was partially offset by our net operating loss. Our
operating activities used cash in the amount of $5 million in 2001 primarily
due to our net operating loss and a decrease in income taxes payable which was
offset by an increase in accrued expenses and other liabilities, equity in
losses of an affiliate, impairment of marketable securities, depreciation and
amortization. Our operating activities used cash in the amount of $2.4 million
in 2000. This was primarily due to gain on sale of available for sale
marketable securities, an increase in inventories and an increase in other
accounts receivable and prepaid expenses, that were partially offset by
depreciation and amortization.

Our
investing activities used cash in the amount of $2.5 million in 2002 primarily
due to purchase of property and equipment, investment in and loans to
affiliates. Our investing activities provided cash in the amount of $3.4
million in 2001 primarily due to proceeds from sale of available for sale
marketable securities, that was offset by purchase of property and equipment,
investment in affiliates and payment for the purchase of assets from Preview.
Our investing activities used cash in the amount of $13.8 million in 2000
primarily due to investments in available for sale marketable securities and in
Tamir Fishman II LLC and purchase of property and equipment, that were
partially offset by proceeds from sale of available for sale marketable
securities.

In
2002, our financing activities did not use or provide any cash. Our financing
activities used cash in the amount of $0.26 million in 2001 due to purchase of
treasury shares. Our financing activities provided cash in the amount of $0.16
million in 2000 primarily due to the proceeds from exercise of options, which
was partially offset by purchase of treasury shares.

34

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We
had working capital of approximately $22.7 million at December 31, 2002, $24.6
million at December 31, 2001 and $34.5 million at December 31, 2000.  Our ratio of current assets to current
liabilities was 3.4 at December 31, 2002, 3.9 at December 31, 2001 and 3.7 at
December 31, 2000.

We
believe that our accumulated cash, in conjunction with cash generated from
operations and available funds, will be sufficient to meet our cash
requirements for working capital and capital expenditures for at least the next
12 months. Thereafter, if cash generated from operations is insufficient to satisfy
our liquidity requirements, we may sell additional equity or debt securities or
obtain credit facilities.

Research and Development, Patents and Licenses, etc.

The software industry is
characterized by rapid product change 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 utilizing, among other things, our proprietary security algorithms.
We work closely with our customers and prospective customers to determine their
requirements and to design enhancements and new features to meet their needs.
We intend to expand our research and development efforts, and are currently
developing new products that incorporate both technology presently used in our
products and technology developed for new applications.  Our research and development activities have
led to periodic releases of improved versions of our HASP, HARDLOCK, Privilege
and eSafe products, which offer increased functionality.  In addition, our research and development
efforts have resulted in the release of eToken in June 2000.  We intend to expand our research and
development efforts, and we are currently developing new products that
incorporate both technology presently used in our products and technology that
we are developing for new applications.

Research and development
expenditures increased to approximately $13.8 million during 2002, as compared
to $12.4 million during 2001 and $9.8 million during 2000.  This increase was due to an increase in
compensation expenses resulting from the hiring of new research and development
personnel, primarily for the development of eToken and for the research and
development center, that we opened in connection with the Preview acquisition.

Trend Information

There is a trend toward
integration of security software inside pre-configured, easy to install
hardware appliances.  Although Aladdin
has introduced its own appliance hardware integrated with eSafe Gateway and
eSafe Mail, it only addresses small and medium organizations.  We are working on strategic alliances with
major hardware manufacturers to introduce an appliance for the high-end of the
market. In addition there is an element of service that must be provided to
customers when selling hardware devices. If we are unable to correctly address
the market demands for Content Security Appliances and the associated services,
our competitive position, results of operations and financial condition may be
adversely affected.

The Internet has become a
critical tool for many companies.  The
importance of the Internet, coupled with the fact that advanced technology has
enabled the development of vandals and viruses that can travel over the
Internet at the speed of light, causes companies to demand of us increasingly
fast and effective responses to these vandals and viruses.  In order to meet this challenge, we are
working on the development of enhanced versions of eSafe Gateway and eSafe Mail
products. We are also continuing to invest in research and development in order
to improve the quality of our products and to introduce new more effective
products that will deliver more proactive solutions for blocking vandals/viruses.  The inability to develop such responses to
these vandals/viruses or provide adequate service to our customers could have a
material adverse effect on our business results.

35

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A substantial portion of
our revenues each year are generated by repeat orders from our existing
customer base. Software developers that have integrated HASP and Hardlock
products into their software packages, generally continue to purchase our
products. We expect that we will continue to generate substantial revenues from
sales of our software security products to current customers.

Finally, there is a
continuing worldwide slowdown in technology-based companies.  We can give no assurances that this global
downturn will not affect our revenues, results of operations and the market
price of our ordinary shares.

Item
6.               Directors,
Senior Management and EmployeesDirectors and Senior Management

As of May 31, 2003, our
directors, senior management and key employees are as follows:

|Name                      | Age | Position
  with the Company                                
|------------------------- | --- | -----------------------------------------------------------
|                          |     |                                                            
|                          |     |                                                            
|Jacob (Yanki) 
  Margalit | 40  | Chairman of the Board and Chief Executive Officer          
|                          |     |                                                            
|David Assia(1)            | 51  | Director                                                   
|                          |     |                                                            
|Menahem Gutterman(1)(2)   | 64  | Director                                                   
|                          |     |                                                            
|Orna Berry(1)(2)          | 54  | Director                                                   
|                          |     |                                                            
|Yigal Bar Yossef          | 55  | Director                                                   
|                          |     |                                                            
|Dany Margalit             | 35  | Director and Executive Vice President, Technologies        
|                          |     |                                                            
|Erez Rosen                | 42  | Chief Financial Officer                                    
|                          |     |                                                            
|Ami Dar                   | 43  | President of Aladdin Knowledge Systems Inc.                
|                          |     |                                                            
|Steve Langerock           | 48  | Chief Executive Officer of Aladdin Knowledge Systems
  Inc.
|                          |     |                                                            
|Leedor Agam               | 39  | Vice President eBusiness and eToken Solutions.             
|                          |     |                                                            
|Dror Irani                | 43  | Vice President, eSafe Business Unit Manager                
|                          |     |                                                            
|Avishai Ziv               | 44  | Vice President Business Development                        
|                          |     |                                                            
|Shimon Gruper             | 42  | Executive Vice President, Internet Technologies            
|                          |     |                                                            
|Avi Barir                 | 49  | Vice President Software Commerce                           

---

36

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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 1987-1993 and has served as a director since 1985.

David Assia has served as a director of
our company since 1993.  Mr. Assia is a
co-founder of Magic Software Enterprises Ltd. and Mashov Computers Ltd.  Mr. Assia currently serves as the Executive
Chairman of Magic Software.  From 1983
to 1996, Mr. Assia was the Chief Executive Officer and Chairman of Magic
Software.  Mr. Assia is also a member of
the boards of directors of Radview Software Ltd, Babylon Ltd and the Weizmann
Institute of Science. Mr. Assia serves as the Vice-Chairman of the Israel
Software Houses Association. Mr. Assia holds a B.A. and an M.B.A. from Tel Aviv
University.

Dr. Menahem Gutterman has been an outside
director since December 31, 2000.  Dr.
Gutterman has served as Executive Vice President and Head of the Operations
Information Systems Division of Israeli Discount Bank Ltd since 1992.  Dr. Gutterman served as General Managers
Assistant at Israel Discount Bank Ltd. from 1981-1992.  Prior to joining Israel Discount Bank Ltd.,
Dr. Gutterman served as Vice President of Sales and Services at Elscint Ltd.,
as well as Managing Director of Clal Systems. 
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.

Dr. Orna Berry has been an outside
director since December 31, 2001.  Dr.
Berry is a venture partner in Gemini Israel Funds Ltd. and the active
chairperson in both Lambda Crossing, Ltd., and in Riverhead Networks, Inc.
since August 2000.  Dr. Berry served as
the Chief Scientist of the Ministry of Industry and Trade of the Government of
Israel from 1997-2000 and co-president of ORNET Data Communications
Technologies Ltd. from 1993-1997.  From
1992-1993, Dr. Berry served as a consultant to Intel Communications Division
and Elbit Systems, Ltd.  Dr. Berry
receiver her Ph.D. in Computer Science from the University of Southern
California and M.A. and B.A. degrees in Statistics and Mathematics from Tel
Aviv University and Haifa University.

Yigal Bar Yossefhas served as a director
since December 11, 2002. Since 2001, Mr. Yossef serves as Senior Vice President
of Marketing for Amdocs Management Limited and is responsible for Amdocs newly
acquired Clarify Division. Prior to joining Amdocs, Mr. Bar-Yossef served as
Managing Director and CEO of Pelephone Communications Ltd., Israels pioneer
cellular company, jointly owned at the time by BEZEQ. He was also the CEO of
Digital from 1992 to 1997. Mr Bar Yosef holds an MBA from Hebrew University.

Dany Margalit joined our company in 1987
as Research and Development Manager and has served as a director since 1994. In
1989, Mr. Margalit was appointed Executive Vice President, Research and Development.  In 1998, he was appointed Executive Vice
President, Chief Technology Officer. Mr. Margalit holds a B.Sc. in
Mathematics and Computer Science from Tel Aviv University.

Erez Rosen has been Vice President for
Finance and Chief Financial Officer since 1998.  In 1997, Mr. Rosen served as the head of Finance and
Administration of NDS Technologies  an affiliate of News Corp. From 1994 to
1996, Mr. Rosen was employed as the Financial Controller of the Michael Levi
Group, a private industrial group. From 1988 to 1994, Mr. Rosen was employed by
the BASF Group in Germany, and Italy, where he served in various finance and
administration positions. Mr. Rosen holds a BA in Economics from the Hebrew
University in Jerusalem, an MBA from INSEAD in Fontainebleau, France and has
completed the General Manager Program (TGMP) at Harvard Business School.

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Ami Dar has been President of Aladdin
Knowledge Systems Inc., since October 1993. 
From 1988 to 1993, Mr. Dar served as our International Marketing
Manager. Ami is also the founder and chairman of Actions Without Borders.

Steve Langerock has been Chief Executive
Officer of Aladdin Knowledge Systems Inc. since 1996.  He joined Glenco in 1995 and was promoted to Chief Financial
Officer and General Manager in 1996. 
Prior to joining Glenco, he was Administration/Operations Manager for
Advantest, a world leader in the production of semiconducter test
equipment.  Mr. Langerock has extensive
experience in the sales, production and financial arenas.  Mr. Langerock holds a BA in Business
Management and Accounting and is a CPA and CPIM.

Leedor Agamjoined us in January 2001 as
Vice-President eBusiness and eToken Solutions, heading up the companys
portable authentication and network security product line. Prior to joining us,
Mr. Agam served as Vice President of Business Development for Cylink/AR where
he focused on technology acquisition and partnerships, and also held several
management positions in Marketing and Channel management where he gained
extensive experience in bringing to market high technology security solutions.
Mr. Agam received an MBA from City University of London, and a technology
bachelors degree in Industrial Management from Tel Aviv University.

Dror Irani joined our company in 1999 as
Vice President for Sales of the Internet Security Unit.  In 2000, Mr. Irani was promoted to be the
Corporate Vice President Sales (for all of our product lines). In 2003 Mr.
Irani took the position of Vice President, eSafe Business Unit Manager. In
1998, Mr. Irani served as the Vice President of Sales and Marketing for
Perfecto Technologies, a start up in the area of Internet security. From 1993
to 1997, Mr. Irani served in several senior sales positions at Comverse Network
Systems. This included 3 years at Comverse headquarters in the United States.
Mr. Irani holds an MBA and an MA in Economics, as well as BSc. in Computer
Science from the Hebrew University in Jerusalem.

Avishai Ziv was appointed Vice President
Business Development on January 7, 2001. 
Mr. Ziv previously served as Vice President of Business Development of
Runway Ltd. and Managing Director of C.D.I. Systems Ltd.  Mr. Ziv also served as a management
consultant to major industrial and hi-tech corporations on strategy and
business development and to the Israeli Ministry of Foreign Affairs.  Mr Ziv holds a bachelors of arts degree in
Political Science and Labor Studies and a masters in Labor studies from Tel
Aviv University.

Shimon Gruperhas been Executive Vice
President of Internet Technologies of our company since the acquisition of
EliaShim in December of 1998.  Mr.
Gruper founded EliaShim in 1983 and served as its Chief Executive Officer until
December 1998.  He previously served in
a computer unit of the Israeli Air Force.

Avi Barir has been our Vice President of
Software eCommerce since 2000. He is responsible for Aladdins Digital Rights
Management (DRM) products, including HASP, Hardlock, Privilege, and the newly
acquired products of Preview Systems: Ziplock and Vbox. From 1999 to 2000 Mr.
Barir served as the Vice President of Marketing in BreezeCom (NASDAQ: BRZE), a
company specializing in broadband wireless solutions. Between 1997 and 1999 Mr.
Barir served as the Associate Vice President of Marketing in ECI Telecoms
(NASDAQ: ECIL) Access Solutions SBU. During the first 18 years of his career
Mr. Barir held various research and development and sales positions in the
defense industry and in the information technology industry. Mr. Barir holds a
B.Sc. degree in Electronics Engineering from the Technion - Israel Institute of
Technology, and a MBA degree from Tel Aviv University.

38

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Yanki and Dany Margalit
are brothers.

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.

Compensation

During the year ended
December 31, 2002, we paid in the aggregate direct remuneration to our
directors and officers as a group who served in the capacity of director or
executive officer during such year (not including our subsidiaries),
approximately $1,275,758. This amount includes directors fees and expenses,
but does not include amounts expended by us for automobiles made available to
our officers, expenses (including business travel, professional and business
association dues and expenses) reimbursed to officers and other fringe benefits
commonly reimbursed or paid by companies in Israel.  In addition, we set aside or accrued approximately $160,749 to
provide pension, retirement or similar benefits.

Certain of the
compensation paid to our directors in 2002 is paid in the form of options under
our Aladdin Knowledge Systems Ltd. 2001 Israeli Share Option Plan.  This Plan is described in full under
Employee Share Option Plans below.  
In 2002, we granted options to purchase 2,500 ordinary shares under the
2002 Plan to each of Mr. Assia, Dr. Gutterman and Dr. Berry.  The exercise price of the options was $1.20
and they vest in various portions over the course of the 12 to 48 months from
the date of grant.

Board Practices

Board
of Directors

Although our shareholders
are free to determine the size of our board, until such a determination is
made, our Articles of Association provide for a board of directors of not less
than two, and not more than eight members. Each director, with the exception of
outside directors who are elected to serve set periods of time as described
below, is elected to serve until the next annual general meeting of
shareholders and until his successor has been elected. Officers serve at the
discretion of the board of directors.

Substitute Directors

Our Articles of
Association provide that any director may, by written notice to us, appoint
another person to serve as a substitute director and may cancel such
appointment. A person may not serve as a substitute director for more than one
director and may not serve as both director and as a substitute director.

The term of appointment
of a substitute director may be for one meeting of the board of directors or
for a specified period or until notice is given of the cancellation of the
appointment.  To our knowledge, no
director currently intends to appoint any other person as a substitute
director, except if the director is unable to attend a meeting of the board of
directors.

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Outside Directors

The Israeli Companies Law
(the Companies Law), requires Israeli companies with shares that have been
offered to the public in or outside of Israel to appoint two outside
directors.  Dr. Gutterman was elected as
an outside director at our Annual Meeting of Shareholders on December 31, 2000
and Dr. Orna Berry was elected as an outside director at our Annual Meeting of
Shareholders on December 31, 2001.

No person may be
appointed as an outside director if the person or the persons relative,
partner, employer or any entity under the persons control, has or had, on or
within the two years preceding the date of the persons appointment to serve as
outside director, 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; or                                                                                                                                                                                                                                                                                                                                                                                                                   
|  |                                                                                                                                                                                                                                                                                                                                                                                                                               
| | service as an office holder. An office holder is
  defined in the Companies Law as a (i)
  director, (ii) general manager, (iii) chief business manager, (iv) deputy
  general manager, (v) vice general manager, (vi) any other person assuming the
  responsibilities of any of the forgoing positions without regard to such
  persons title or (vii) any other manager directly subordinate to the
  managing director.

No person may serve as an
outside director if the persons position or other business activities create,
or may create, a conflict of interest with the persons responsibilities as an
outside director or may otherwise interfere with the persons ability to serve
as an outside director.  If, at the time
outside directors are to be appointed, all current members of the board of
directors are of the same gender, then at least one outside director must be of
the other gender.

Outside directors are to
be elected by a majority vote at a shareholders meeting, provided that either:

| | the majority of shares voted at the meeting, including
  at least one-third of the shares held by non-controlling shareholders voted
  at the meeting, vote in favor of election of the director; or
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                     
| | the total number of shares held by non-controlling
  shareholders voted against the election of the director does not exceed one
  percent of the aggregate voting rights in the company.           

The initial term of an
outside director is three years and may be extended for an additional three
years.  Outside directors may be removed
only by the same percentage of shareholders as is required for their election,
or by a court, and then only if the outside directors cease to meet the
statutory qualifications for their appointment or if they violate their duty of
loyalty to the company.  Each committee
of a companys board of directors must include at least one outside
director.

40

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

In addition, pursuant to
the listing requirements of the NASDAQ National Market, we are required to have
at least two independent directors on our board of directors.  Dr. 
Gutterman and Dr. Orna Berry qualify as independent directors under the
NASDAQ National Market requirements.

Audit Committee

The Companies Law
requires public companies to appoint an audit committee.  The responsibilities of the audit committee
include identifying irregularities in the management of the companys business
and approving related party transactions as required by law.  An audit committee must consist of at least
three directors, including the outside directors of the company.  The chairman of the board of directors, any
director employed by or otherwise providing services to the company, and a
controlling shareholder or any relative of a controlling shareholder, may not
be a member of the audit committee.

We are also required by
the NASDAQ National Market to establish an audit committee, at least a majority
of whose members is independent of management. Mr. Assia, Dr. Gutterman and Dr.
Berry serve as members of our audit committee. 
Dr. Gutterman and Dr. Berry, our independent directors, both serve on
the audit committee.

Internal
Auditor

Under
the Companies Law, the board of directors must appoint an internal auditor,
nominated by the audit committee.  The role of the internal auditor is to
examine, among other matters, whether the companys actions comply with the law
and orderly business procedure.  Under the Companies Law, the internal
auditor may be an employee of the company but not an office holder, or an
affiliate, or a relative of an office holder or affiliate, and he may not be
the companys independent accountant or its representative.

Employees

The
following table sets forth for the last three fiscal years, the number of our
employees engaged in the specified activities:

|                              |  |  | Year ended
  December 31, | 
|----------------------------- |  |  | ------------------------- | 
|                              |  |  |                           | 
|Activity                      |  |  | 2002*                     | 
|                              |  |  |                           | 
|Production                    |  |  | 53                        | 
|Research and development      |  |  | 138                       | 
|Marketing and sales           |  |  | 70                        | 
|Customer support              |  |  | 43                        | 
|Administration and management |  |  | 50                        | 
|Total                         |  |  | 354                       | 

*Includes employees for
product lines acquired in the Preview acquisition.

Over the last three
years, we have continued investing in research and development by increasing
the number of staff working in that department.

41

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Certain provisions of the
collective bargaining agreements between the Histadrut (General Federation of
Labor in Israel) and the Coordination Bureau of Economic Organizations
(including the Industrialists Associations) are 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 required minimums.  In addition to salary and other benefits,
certain of our marketing and sales personnel are paid commissions based on our
performance in certain territories worldwide.

Israeli law generally
requires severance pay at a rate of 1 months salary for every year of
employment, which may be funded by Managers Insurance described below, upon
the retirement or death of an employee or termination of employment without
cause (as defined in the law). The payments to Managers Insurance Fund amount
to approximately 8.33% of current wages. Furthermore, Israeli employees and
employers are required to pay predetermined sums to the National Insurance
Institute, which is similar to the United States Social Security
Administration. Such amounts also include payments by the employee for national
health insurance. The total payments to the National Insurance Institute are
equal to approximately 14.6% of the wages (up to a specified amount), of which
the employee contributes approximately 66% and the employer contributes
approximately 34%.

A general practice
followed by us, although not legally required, is the contribution of funds on
behalf of most of our employees to a fund known as Managers Insurance. This
fund provides a combination of savings plan, insurance and severance pay
benefits to the employee, giving the employee payments upon retirement or death
and securing the severance pay, if legally entitled, upon termination of
employment. We decide whether each employee is entitled to participate in the
plan, and each employee who agrees to participate contributes an amount equal
to 5% of his salary towards savings and the employer contributes 8.33% for
severance payments, 5% of his/her salary towards savings and up to 2.5% for
disability.

Our success has been, and
will be, dependent to a large degree on our ability to retain the services of
key personnel and to attract additional qualified personnel in the future.  Competition for such personnel is
intense.  There can be no assurance that
we will be able to attract, assimilate or retain key personnel in the future
and the failure to do so would have a material adverse effect on our business,
financial condition and results of operations.

Employee Share Option Plans

We maintain the following
share option plans for our and our subsidiaries employees, directors and
consultants.  In addition to the
discussion below, see Note 14d. to our Consolidated Financial Statements.

In 2002, our board of
directors adopted the 2002 Israeli Share Option Plan pursuant to which 250,000
ordinary shares were reserved for issuance upon the exercise of options granted
to our (including our subsidiaries) employees, directors, consultants and
service providers.  As of May 31, 2003,
options to purchase 235,500 of such ordinary shares at an exercise price per
share of $1.20 were outstanding and options to purchase 14,500 ordinary shares
were available for future grants.  The
exercise prices of options granted under the plan are the market price of the
ordinary shares on the date of grant.  
Under the 2002 Plan, options terminate ten years following the date of
grant if not exercised earlier.  None of
the outstanding options are vested.  The
non-vested options referred to above vest between October 24, 2003 and October
24, 2006.  The options are not
assignable except by the laws of descent.

42

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In 2001, our board of
directors adopted the 2001 Israeli Share Option Plan pursuant to which 400,000
ordinary shares were reserved for issuance upon the exercise of options granted
to our (including our subsidiaries) employees, directors, consultants and
service providers.  As of May 31, 2003,
options to purchase 299,800 of such ordinary shares at exercise prices per
share ranging from $1.20 to $3.50 were outstanding and options to purchase
100,200 ordinary shares were available for future grants.  The exercise prices of options granted under
the plan are the market price of the ordinary shares on the date of grant.   Under the 2001 Plan, options terminate ten years following the
date of grant if not exercised earlier. 
Of the outstanding options 75,800 are fully vested.  The non-vested options referred to above
vest between October 24, 2003 and October 24, 2006.  The options are not assignable except by the laws of descent.

On October 25, 2000, our
board of directors adopted the 2000 Israeli Share Option Plan pursuant to which
500,000 ordinary shares were reserved for issuance upon the exercise of options
granted to our (including our subsidiaries) employees, directors, consultants
and service providers.  The options
granted under this plan may or may not qualify for special tax treatment under
Section 102 of the Israeli Income Tax Ordinance (New Version) 1961.  As of May 31, 2003, options to purchase
430,000 of such ordinary shares at exercise prices per share ranging from $1.20
to $4.50 were outstanding and options to purchase 70,000 ordinary shares were
available for future grants.  The
exercise prices of options granted under the plan are the market price of the
ordinary shares on the date of grant.  
Under the 2000 Plan, options terminate ten years following the date of
grant if not exercised earlier.  207,942
of the outstanding options are fully vested. 
The remaining options vest between October 24, 2003 and October 24,
2006.  The options are not assignable
except by the laws of descent.

In 1999, our board of
directors adopted the 1999 Israeli Share Option Plan pursuant to which 250,000
ordinary shares were reserved for issuance upon the exercise of options granted
to our (including our subsidiaries) employees, directors, consultants and
service providers.  As of May 31, 2003,
options to purchase 249,050 of such ordinary shares at exercise prices per
share ranging from $1.20 to $7.50 were outstanding and options to purchase 950
ordinary shares were available for future grants.  154,175 of the outstanding options are fully vested. The
remaining options will vest between October 24, 2003 and October 24, 2006.  The terms of these options are substantially
similar to those of the 2000 Israeli share option plan.

In 1998, our board of
directors adopted the 1998 Israeli Share Option Plan pursuant to which 250,000
ordinary shares were reserved for issuance upon the exercise of options granted
to our (including our subsidiaries) employees, directors, consultants and
service providers.  As of May 31, 2003,
options to purchase 235,100 of such ordinary shares were outstanding and
options to purchase 14,900 ordinary shares were available for future
grants.  Of the outstanding options (i)
options to purchase 115,150 ordinary shares are fully vested and are
exercisable at exercise prices ranging from $4.50 to $8.50 per share and (ii)
options to purchase 119,950 ordinary shares are not vested and are exercisable
at $1.20 - $8.50 per share.  The options
referred to in (ii) above will vest between October 24, 2003 and October 24,
2006.  The terms of these options are
substantially similar to those of the 2000 and 1999 Israeli share option plans.

In addition, there are
258,550 outstanding options that were granted to our employees under option
plans between the years 1993 and 1997.

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Share Ownership

All of the persons listed
above, under the caption Directors, Senior Management and Employees who are
employed by us own shares and/or options to purchase ordinary shares.  Except as set forth below, none of the named
directors or employees owns shares and/or options amounting to 1% or more of
our outstanding ordinary shares.  Yanki
Margalit owns 2,149,689 ordinary shares which is 18.7% of our outstanding
capital.  Danny Margalit owns 1,269,195
ordinary shares which is 11.1% of our outstanding capital.

Item
7.               Major
Shareholders and Related Party Transactions

Major Shareholders

The following table sets
forth certain information as of May 31, 2003, regarding beneficial ownership
(as defined in Rule 13d-3 under the Securities Exchange Act of 1924) of
ordinary shares as of May 31, 2003 by each person who is known to own at least
5% of our outstanding ordinary shares. 
The table also includes the number of shares underlying options that are
exercisable within 60 days of May 31, 2003. The voting rights of our major
shareholders do not differ from the voting rights of other holders of our
ordinary shares.

|Name
  and Address |                                                                               |  | Number of Shares Owned |           | Percent of Shares* | 
|------------------ | ----------------------------------------------------------------------------- |  | ---------------------- | --------- | ------------------ | 
|                   |                                                                               |  |                        |           |                    | 
|                   | Yanki Margalit 
  15 Beit Oved Street 
  Tel Aviv 61110, Israel               |  |                        | 2,149,689 |                    | 
|                   |                                                                               |  |                        |           |                    | 
|                   | Dany Margalit 
  15 Beit Oved Street 
  Tel Aviv 61110, Israel                |  |                        | 1,269,195 |                    | 
|                   |                                                                               |  |                        |           |                    | 
|                   | Mills Value Advisor, Inc.
  1108 East Main Street 
  Richmond, Virginia 23219 |  |                        | 2,104,700 |                    | 

*Assumes
the holders beneficial ownership of all ordinary shares that the holder has a
right to purchase within 60 days.

As of May 31, 2003, there
were a total of 80 holders of record of our ordinary shares, of which 50 were
registered with addresses in the United States.  Such United States holders were, as of such date, the holders of
record of approximately 69.7% of our outstanding ordinary shares.

Related Party
Transactions

FAST Multimedia

Prior to June 1994, the
business of FAST was comprised of the software security business that we
acquired on May 26, 1996, and a business relating to the sale of digital
video editing hardware and software products (the Multimedia Business). In
June 1994, FAST sold the Multimedia Business to certain of the then
shareholders of FAST for its market value (the FAST Reorganization), which
equaled approximately $1.99 million (the Multimedia Purchase Price). The
Multimedia Business is currently operated by FAST Multimedia AG (FAST
Multimedia), which is a wholly owned subsidiary of FAST Multimedia Inc. (FAST
Inc.).  Matthias Zahn is a principal
shareholder and the Chief Executive Officer of FAST Inc., and was a director on
our board and a member of our audit committee until February 2001.  The Multimedia Purchase Price was paid
through the issuance of a note by the purchasing shareholders of FAST (the
FAST Note) to FAST. The FAST Note bears interest at a rate of approximately
7% per year. In connection with the FAST Reorganization, FAST Inc. purchased a
promissory note issued by FAST in the aggregate principal amount of DM 2.5
million ($1.6 million). This note was repaid by FAST in June 1995 through
the sale by FAST to FAST Inc. of certain subsidiaries of FAST.   In 2001, we wrote off our portion of the
FAST Note in the aggregate amount of $3,350,000. At the end of 2001 FAST
Multimedia was sold to Pinnacle Systems. In May 2002, we received $261,000 as
our share of this deal.

44

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Amendment to the Employment Terms of Mr. Yanki Margalit, our
Chairman and CEO

In final quarter of 2002 our audit committee,
board of directors and shareholders approved the amendment of the terms of Mr.
Margalits employment. Effective October 2002 Mr. Margalits annual salary is
$150,000.  In addition, commencing in
2002, Mr. Margalit receives an annual performance based bonus equivalent to
1.5% of year to year increases in our annual revenues and commencing in the
fourth quarter of 2002 Mr. Margalit receives a quarterly performance based
bonus equivalent to 3% of our quarterly net profits.  In 2003 Mr. Margalit will also receive options to purchase
100,000 of our ordinary shares at an exercise price per share of $1.20 which
will be subject to a 3 year vesting schedule such that one third of these
options will vest annually.  Mr.
Margalit also receives the use of an automobile from the Company, 25 days of
paid vacation per year as well as other benefits commonly paid by companies in
Israel.

Stock Purchase Plan Commitment of Mr. Yanki Margalit, our
Chairman and CEO

Mr. Margalit has
undertaken to purchase stock on the open market each month during 2003 equal to
15 percent of his net salary. The 12- month purchase plan will take place
irrespective of the price of the stock and subject to applicable law.

Loan Agreements with Officers

In 2000, we entered into
loan agreements with several of our officers pursuant to which we granted these
officers loans in the aggregate amount of $1,150,000 for the purpose of
enabling them to invest in the Tamir Fishman Venture Capital II Ltd shares. The
above loans were linked to the consumer price index and were interest bearing
at the rate of 4% per year. These loan programs were cancelled in January,
2002. Our employees (and former employees) transferred their shares in Tamir
Fishman Venture Capital II Ltd to Aladdin in return for the waiver of the
commitment of the employees regarding the loans granted to them by us (see the
Tamir Fishman investment described above in Item 4:  Business Overview).  In
addition, Aladdin Knowledge Systems Inc. loaned its employees $124,000.  This amount includes money loaned to Aladdin
employees who have since left the company. 
We are currently concluding similar arrangements for our US subsidiary.

Strategic Agreement with Athena Research Ltd.

In December, 1998, we
signed a strategic agreement with Athena Research Ltd. (our former partner in
Aladdin Knowledge Systems Japan Co.), under which we formed a joint venture
named Athena Smartcard Solutions Ltd. which develops and markets smartcard
solutions based on our Smartcard Environment (ASE) technology.  Pursuant to this agreement, we granted
Athena Smartcard Solutions a non-exclusive, perpetual license (that became an
exclusive perpetual license under a technology license agreement entered into
between us and Athena effective as of May, 2001) to use the ASE technology and
all related intellectual property, and Athena Smartcard Solutions assumed all of
the responsibilities for our ASE related business, including marketing, sales
and customer support.  We have ceased
all of our in-house activities with respect to the ASE technology field.  Athena Smartcard Solutions issued us shares
representing 33% of its total issued and outstanding shares.  Between December 1998 and December 31, 2002,
we provided Athena loans in the aggregate amount of $2,383,000.  In the first half of 2003 we provided Athena
with an additional $100,000 loan.

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On March 28, 2001, we
converted $1,053,000 into a convertible bond redeemable at the earlier of five
years from the date of grant or at such time as Athena completes an equity
financing in the amount of $2 million. The bond is convertible into 53 Athena
Class A preferred shares, par value JPY 50,000 (approximately $420) per share.
The remaining $1,430,000 constitutes long-term debt.  We are currently finalizing an agreement with Athena on the basis
of the understanding we have reached with them concerning the repayment terms of
such long-term debt.  Part of the
understanding that we have reached with Athena is that in addition to the
repayment of our loans, Athena will pay us royalties with respect to their
future product sales.  As of May 31,
2003, we own 35.71% of Athena and the aggregate outstanding debt owed to
Aladdin by Athena is $2,483,000.  We
have made a provision in our financial statements with respect to the
likelihood that Athena will be able to repay its debt to us.

Item
8.               Financial
Information

Consolidated Statements and Other Financial Information

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

Legal Proceedings

In November 1999, a claim
was brought against our company in the Tel Aviv District Court by Aladdin
Software Security Benelux B.V., a former distributor of Hardlock and HASP in
Benelux. In addition, in December 1999 the plaintiff also brought an action
before a German court in an attempt to force us to arbitrate our case in Germany.  In this action, the plaintiff claimed that
we acted in bad faith and terminated our relationship with the plaintiff
without providing sufficient notice. The plaintiff sought damages of
approximately $780,000. This claim was settled (including its German court
component which was withdrawn) and court approval of the settlement was
obtained on January 6, 2003. Pursuant to the terms of the settlement, we agreed
to pay the sum of $275,000 and provide 1,208 of our eToken products.

On May 3, 2002, a claim
was brought against our United States subsidiary, Aladdin Knowledge Systems,
Inc. by Network Commerce Inc. In this action, the plaintiff claimed that our
software, including Privilege SCP infringed the plaintiffs United States
patent. The plaintiff requested a preliminary and permanent injunction, damages
and attorneys fees. Aladdin denied the allegations of the claim and asserted
that plaintiffs patent is invalid. 
This claim was settled in December 2002. Pursuant to the terms of the
settlement, which received the required court approval in April 25, 2003, we
agreed to pay $200,000. The settlement included a mutual release, license and
covenant not to sue.

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On October 2, 2002, a
claim was brought by Hilgraeve, Inc. against us, our United States subsidiary
and other companies, including one of our resellers who we agreed to represent
and indemnify. In this action, which is currently in the discovery stage, the
plaintiff claims that our eSafe product infringes the plaintiffs United States
patent. The plaintiff has requested a preliminary and permanent injunction,
damages and reasonable attorney fees.

Except as set forth
above, we are not party to any material litigation and are not aware of any
pending or threatened litigation that would have a material adverse effect on
our business.

Dividend Distributions

In the event that cash
dividends are declared in the future, such dividends will be paid in NIS.  We do not intend to pay cash dividends in
the foreseeable future.

Significant Changes

There
have not been any significant changes in the company since the date of our
financial statements.

Item
9.               The
Offer and Listing

Offer and listing details

In October 1993, we
consummated an initial public offering of 1,125,000 ordinary shares.  At such time, the ordinary shares were
quoted on The NASDAQ National Market. 
We changed our NASDAQ ticker symbol from ALDNF to ALDN on May 10,
1998.  The ordinary shares are not listed
on any other stock exchange and have not been publicly traded outside the United
States.

The table below sets
forth the high and low reported sales prices of the ordinary shares, as
reported by NASDAQ during the indicated fiscal quarters:

|Period              |  | High |        | Low |  
|------------------- |  | ---- | ------ | --- | -
|                    |  |      |        |     |  
|May 2003            |  | $    | 4.00   |     | $
|April 2003          |  | $    | 3.20   |     | $
|March 2003          |  | $    | 2.91   |     | $
|February 2003       |  | $    | 3.18   |     | $
|January 2003        |  | $    | 3.38   |     | $
|December 2002       |  | $    | 2.67   |     | $
|First Quarter 2003  |  | $    | 3.38   |     | $
|Fourth Quarter 2002 |  | $    | 2.67   |     | $
|Third Quarter 2002  |  | $    | 2.35   |     | $
|Second Quarter 2002 |  | $    | 3.80   |     | $
|First Quarter 2002  |  | $    | 3.86   |     | $
|Fourth Quarter 2001 |  | $    | 4.56   |     | $
|Third Quarter 2001  |  | $    | 4.15   |     | $
|Second Quarter 2001 |  | $    | 5.15   |     | $
|First Quarter 2001  |  | $    | 5.91   |     | $
|2002                |  | $    | 2.81   |     | $
|2001                |  | $    | 5.91   |     | $
|2000                |  | $    | 44.75  |     | $
|1999                |  | $    | 19.313 |     | $
|1998                |  | $    | 17.00  |     | $

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Item
10.               Additional
Information

Memorandum and Articles of Association

Articles of Association

In
February, 2000, the Companys Ordinance (New Version) 1983 was replaced by the
Companies Law.  Since our Articles were
approved before the enactment of the Companies Law, they are not always
consistent with the provisions of the new law. 
At our next shareholders meeting we intend to propose the adoption of
revised Articles of Association that conform with the provisions of the
Companies Law. In all instances in which the Companies Law changes or amends
provisions in the Companies Ordinance, and as such, our Articles are not
consistent with the Companies Law, the provisions of the Companies Law shall
apply unless specifically stated otherwise in the Companies Law.  Similarly, in all places that our Articles
refer to a Section of the Companies Ordinance that has been replaced by the
Companies Law, the Articles shall be understood to be referring to the relevant
Section of the Companies Law.

Our shareholders approved
our Articles of Association on August 15, 1993. Our objectives as stated in our
Articles and in our Memorandum of Association are to engage in any lawful
activity.

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

Holders of ordinary
shares have one vote per share, and are entitled to participate equally in the payment
of dividends and share distributions and, in the event of our liquidation, in
the distribution of assets after satisfaction of liabilities to creditors. Our
Articles may be amended by a resolution carried at a General Meeting by 75% 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 require that
we hold our annual general meeting of shareholders each year no later than 15
months from the last annual meeting, at a time and place determined by the
board of directors, upon at least 21 days prior notice to our
shareholders.  No business may be
commenced until a quorum of two or more shareholders are present in person or
by proxy.  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:

48

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

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

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

The Companies Law

The
Companies Law codifies the fiduciary duties that office holders, including
directors and executive officers, owe to a company.

The
Companies Law requires that an office holder of a company promptly disclose any
personal interest that he or she may have and all related material information
known to him or her, in connection with any existing or proposed transaction by
the company. In addition, if the transaction is an extraordinary transaction,
as defined under Israeli law, the office holder must also disclose any personal
interest held by the office holders spouse, siblings, parents, grandparents,
descendants, spouses descendants and the spouses of any of the foregoing, or
by any corporation in which the office holder is a 5% or greater shareholder,
holder of 5% or more of the voting power, 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 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.

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In
the case of a transaction that is not an extraordinary transaction, after the
office holder complies with the above disclosure requirement, only board
approval is required unless the Articles of Association of the company provide
otherwise.  The transaction must not be
adverse to the companys interest.  If
the transaction is an extraordinary transaction, then, in addition to any
approval required by the Articles of Association, it must also be approved by
the audit committee and by the board of directors, and, under specified
circumstances, by a meeting of the shareholders.

Subject
to certain exceptions provided for in the regulations to the Companies Law,
agreements regarding directors terms of compensation require the approval of
the audit committee, board of directors and shareholders.  In all matters in which a director has a
personal interest, including matters of his/her terms of compensation, he/she
shall not be permitted to vote on the matter or be present in the meeting in
which the matter is considered. 
However, should a majority of the audit committee or of the board of
directors have a personal interest in the matter then:

| | all of the directors shall be
  permitted to vote on the matter and attend the meeting in which the matter is
  considered; and
|- | -------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                
| | the matter requires approval
  of the shareholders at a general meeting.                                                       

According
to the Companies Law, the disclosure requirements discussed above also apply to
a controlling shareholder of a public company. 
In general, extraordinary transactions with a controlling shareholder or
in which a controlling shareholder has a personal interest, and agreements
relating to employment and compensation terms of a controlling shareholder
require the approval of the audit committee, the board of directors and the
shareholders of the company. The term controlling shareholder is defined for
these purposes as a shareholder who has the ability to direct the activities of
a company, other than if this power derives solely from the shareholders
position on the board of directors or any other position with the company.  The definition also includes shareholders
that hold 25% or more of the voting rights if no other shareholder owns more
than 50% of the voting rights in the company. The shareholder approval must
either include at least one-third of the shares held by shareholders who are
present in person or by proxy at the meeting (without taking abstaining votes
into account) that do not have a personal interest in the proposed transaction,
or, alternatively, the total shareholdings of the disinterested shareholders
who vote against the transaction must not represent more than one percent of
the voting rights in the company.

In
addition, a private placement of securities that will increase the relative
holdings of a shareholder that holds five percent or more of the companys
outstanding share capital, assuming the exercise of all of the securities
convertible into shares held by that person, or that will cause any person to
become, as a result of the issuance, a holder of more than five percent of the
companys outstanding share capital, requires approval by the board of
directors and the shareholders of the company. 
However, subject to certain exceptions, shareholder approval will not be
required if the aggregate number of shares issued pursuant to such private
placement, assuming the exercise of all of the convertible securities into
shares being sold in such a private placement, comprises less than twenty
percent of the voting rights in a company prior to the consummation of the
private placement.  Any placement of
securities that does not fit the above description may be issued at the
discretion of the Board of Directors.

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

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| | 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  under the Companies Law.

In
addition, any controlling shareholder, any shareholder who knows that it
possesses power to determine the outcome of a shareholder vote and any
shareholder who has the power to appoint or prevent the appointment 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. The Companies Law requires that specified
types of transactions, actions and arrangements be approved as provided for in
a companys Articles of Association and in some circumstances by its audit
committee, board of directors and by its shareholders. In general, the vote
required by the audit committee and the board of directors for approval of
these matters, in each case, is a majority of the disinterested directors
participating in a duly convened meeting.

Material Contracts
The asset acquisition
from Preview Systems, Inc. for $5.2 described above in Item 4 Information on
the Company - History and Development of the Company is hereby incorporated by
reference and further modified by the agreement attached as Exhibit 4.1 to this
annual report.

The Tamir Fishman
investment described above in Item 4 Information on the Company - History and
Development of the Company is hereby incorporated by reference and further
modified by the agreements attached as Exhibits 4.2, 4.3 and 4.4 to this annual
report.

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 and our
Memorandum and Articles of Association, both residents and non-residents of
Israel may freely hold, vote and trade ordinary shares.

Taxation

The
following is a summary of some of the current tax law applicable to companies
in Israel, with special reference to its effect on us.  The following also
contains a discussion of specified Israeli tax consequences to shareholders of
our company and Government tax benefits that we benefit from.  To the
extent that the discussion is based on tax legislation that has not been subject
to judicial or administrative interpretation, there can be no assurance that
the views expressed in the discussion will be accepted by the tax authorities
in question.

The following discussion is not intended, and
should not be construed, as legal or professional tax advice and is not
exhaustive of all possible tax considerations.

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General Corporate Tax Structure

In general, Israeli
companies are currently subject to Company Tax at the rate of 36% of taxable
income.   However, the effective tax
rate payable by a company, which derives income from an Approved Enterprise (as
further discussed below), may be considerably less.

Law for
the Encouragement of Capital Investments, 1959

Certain of our facilities
have been granted Approved Enterprise status under the Law for the
Encouragement of Capital Investments, 1959, as amended (the Investment
Law).  The Investment Law provides that
a capital investment in eligible facilities may, upon application to the Israel
Investment Center, be designated as an Approved Enterprise.  Each certificate of approval for an Approved
Enterprise relates to a specific investment program delineated both by its
financial scope, including its capital sources and its physical characteristics,
e.g.,
the equipment to be purchased and utilized pursuant to the program.  The tax benefits derived from any such
certificate of approval relate only to taxable income attributable to the
specific Approved Enterprise.

Taxable income of a
company derived from an Approved Enterprise is subject to Company Tax at the
rate of 25% (rather than 36% as stated above) for the Benefit Period: a
period of seven years commencing with the year in which the Approved Enterprise
first generated taxable income (limited to twelve years from commencement of
production or fourteen years from the date of approval, whichever is earlier)
and, under certain circumstances (as further detailed below), extending to a
maximum of ten years from the commencement date.  Notwithstanding the foregoing, taxable income of a company
located in certain geographic locations, derived from an Approved Enterprise
approved after January 1, 1997, is tax exempt for the first two years of the
Benefit Period and is taxed at a rate of 25% for the remainder of the Benefit
Period.  In the event that a company is
operating under more than one approval or that only part of its capital
investments are approved (a Mixed Enterprise), its effective Company Tax rate
is the result of a weighted combination of the various applicable rates.

A company, which
qualifies as a Foreign Investors Company, is entitled to further reductions
in the tax rate normally applicable to Approved Enterprises.  Such benefits will be granted only to
enterprises seeking approval not later than December 31, 2002. Subject to
certain conditions, a Foreign Investors Company is a company which has more
than 25% of its combined shareholders investment in share capital (in terms of
rights to profits, voting and the appointment of directors) and in long term shareholders
loans made by persons who are not residents of Israel.  The percentage owned by nonresidents of
Israel for any tax year will be determined by the lowest percentage of any of
the above rights held by nonresidents during that year.  Such a company will pay Company Tax at
reduced rates for an extended ten-year (rather than the otherwise applicable
seven-year) period and is exempt from any other tax on the undistributed income
from its Approved Enterprise:

For a company with foreign investment of:

|                              |  |  | Company Tax Rate | 
|----------------------------- |  |  | ---------------- | 
|                              |  |  |                  | 
|Over 25% but less than 49%    |  |  | 25%              | 
|49% or more but less than 74% |  |  | 20%              | 
|74% or more but less than 90% |  |  | 15%              | 
|90% or more                   |  |  | 10%              | 

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Should
our foreign shareholdings exceed 25%, future Approved Enterprises would qualify
for reduced tax rates for an additional three years, after the seven years
mentioned above. However, there can be no assurance that we will attain
approval for additional Approved Enterprises or that the provisions of this Law
will not change or that the above-mentioned shareholding proportion will be
reached for each subsequent year.

In addition, a company
owning an Approved Enterprise approved after April 1, 1986 (or prior thereto
provided no government grants or loans had previously been granted regarding such
enterprise) may elect (as is the case with us) to forego certain Government
grants extended to Approved Enterprises in return for an alternative package
of tax benefits (the Alternative Package). 
Under the Alternative Package, a companys undistributed income derived
from an Approved Enterprise will be exempt from Company Tax for a period of
between two and ten years, depending on the geographic location of the Approved
Enterprise within Israel, and such company will be eligible for the tax benefits
under the Investment Law for the remainder of the benefits period.

A company that has
elected the Alternative Package and that subsequently pays a dividend out of
income derived from the Approved Enterprise(s) during the tax exemption period
will be subject to Company Tax in the year the dividend is distributed in
respect of the amount distributed (including the company tax thereon) at the
rate that would have been applicable had we not elected the Alternative Package
(generally 25%).  The dividend recipient
is taxed at the reduced rate applicable to dividends from Approved Enterprises
(15% as compared to 25%), if the dividend is distributed during the tax
exemption period or within a specified period thereafter. (In the event,
however, that the company also qualifies as a Foreign Investors Company, there
is no such time limit.)  We must
withhold this tax at source, regardless of whether the dividend is converted
into foreign currency.

Subject to certain
provisions concerning income subject to the Alternative Package, all dividends
are considered to be attributable to the entire enterprise and the effective
tax rate is the result of a weighted combination of the various applicable tax
rates.

The Investment Law also
provides that an Approved Enterprise is entitled to accelerated depreciation on
its property and equipment that are included in an approved investment program.
We have not utilized this benefit. The tax incentives received by or to be
received by the company in accordance with the Investment Law remain subject to
final ratification by the Israel Investment Center and final determination by
the Israel Tax Authority, such ratification and determination being conditional
upon fulfillment of all terms of the approved program.

As above mentioned, certain
of our facilities have been granted Approved Enterprise status.  However, there can be no assurance that we
will attain approval for additional Approved Enterprises, or that the
provisions of this Law will not change, or that the above-mentioned shareholding
proportion will be reached and/or maintained.

Law for the Encouragement of Industry (Taxes), 1969

The following preferred
corporate tax benefits, among others, are available to Industrial Corporations.
We believe that we are an Industrial Corporation:

| | deduction of purchases of know-how and patents over
  eight years for tax purposes;                                                                                          
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                              
| | right to elect, under specified conditions, to file
  a consolidated tax return with additional related Israeli industrial
  companies and an industrial holding company; and
|  |                                                                                                                                                                              
| | deduction of certain share issuance expenses over
  three years for tax purposes.                                                                                            

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Taxation under Inflationary Conditions

The Income Tax Law
(Inflationary Adjustments), 1985 (the Inflationary Adjustments Law)
represents an attempt to overcome the problems presented to a traditional tax
system by an economy undergoing rapid inflation.  The Inflationary Adjustments Law is characterized by a high
degree of complexity and its salient features can be described generally as
follows:

| | a special tax adjustment for the preservation of
  equity whereby certain corporate assets are classified broadly into Fixed
  (inflation resistant) Assets and Non-fixed (soft) Assets.  Where a corporations equity, as defined
  in such law, exceeds the depreciated cost of Fixed Assets, a tax deduction
  which takes into account the effect of the annual inflationary change on such
  excess is allowed (up to a ceiling of 70% of taxable income in any single tax
  year, with the unused portion permitted to be carried forward on a linked
  basis).  If the depreciated cost of
  Fixed Assets exceeds a corporations equity, then such excess multiplied by
  the annual inflation change is added to taxable income.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | depreciation deductions on Fixed Assets and losses
  carried forward are adjusted for inflation based on the increase in the
  Israeli Consumer Price Index.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | the law also provides for the full taxation of gains
  from the sale of certain traded securities, which would otherwise be taxed at
  a reduced rate when derived by certain categories of corporate taxpayers.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

Israeli Capital Gains Tax

Until the end of the year
2002 and provided we maintained our status as an industrial corporation,
capital gains from the sale of our securities were generally exempt from
Israeli Capital Gains Tax.  This
exemption did not apply to a shareholder whose taxable income is determined
pursuant to the Israeli Income Tax Law (Inflationary Adjustments), 1985, or to
a person whose gains from selling or otherwise disposing of our securities are
deemed to be business income.

As a result of the recent
tax reform legislation in Israel, gains from the sale of our ordinary shares
derived from January 1, 2003 and on will in general be liable to capital gains
tax of up to 15%.  This will be the case
so long as our securities remain listed for trading on the NASDAQ. However,
according to the tax reform legislation, non-residents of Israel will be exempt
from any capital gains tax from the sale of our securities so long as the gains
are not derived through a permanent establishment that the non-resident
maintains in Israel, and so long as our securities remain listed for trading as
described above.  These provisions
dealing with capital gains are not applicable to a person whose gains from
selling or otherwise disposing of our securities are deemed to be business
income or whose taxable income is determined pursuant to the Israeli Income Tax
Law (Inflation Adjustments), 1985; the latter law would not normally be
applicable to non-resident shareholders who have no business activity in
Israel.

In any event, under the
US-Israel Tax Treaty, a US treaty resident may in general only be liable to
Israeli capital gains tax on the sale of our ordinary shares (subject to the
provisions of Israeli domestic law as described above) if that US treaty
resident holds 10% or more of the voting power in our company.

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Israeli Tax on Dividend Income

Israeli tax at a rate of
25% is generally withheld at source from dividends paid to Israeli individuals
and non-residents; in general, no withholding tax is imposed on dividends paid
to Israeli companies (subject to the provision of the Israeli Income Tax
Ordinance).  The applicable rate for
dividends paid out of the profits of an Approved Enterprise is 15%.  These rates are subject to the provisions of
any applicable tax treaty.

Under
the US-Israel Tax Treaty, Israeli withholding tax on dividends paid to a US
treaty resident may not in general exceed 25%, or 15% in the case of dividends
paid out of the profits of an Approved Enterprise.  Where the recipient is a US corporation owning 10% or more of the
voting stock of the paying corporation and the dividend is not paid from the
profits of an Approved Enterprise, the Israeli tax withheld may not exceed
12.5% subject to certain conditions.

Tax
Consequences if we are a Passive Foreign Investment Company (PFIC)

A
non-U.S. corporation will be classified as a PFIC for U.S. federal income tax
purposes if either (i) 75% or more of its gross income for the taxable year is
passive income, or (ii) on a quarterly average for the taxable year by value
(or, if it is not a publicly traded corporation and so elects, by adjusted
basis), 50% or more of its gross assets produce or are held for the production
of passive income.

Due
to the fact that less than 75% of our gross income in 2002 and in prior years
constituted passive income, as defined for purposes of the Income Test, we do
not believe that application of the above income test would have resulted in
our classification as a PFIC for any of such years. In addition, we do not
believe that application of the above asset test would have resulted in our
classification as a PFIC for any tax year prior to 2001. For 2001 and 2002,
however, it is possible that we could be classified as a PFIC under the asset
test principally as a result of the significant  decline in the public market value of our ordinary shares during
2001 and 2002 and the timing of the required valuations, although there is no
definitive method prescribed in the Code, United States Treasury Regulations or
administrative or judicial interpretations thereof for determining the value of
a foreign corporations assets for purposes of the asset test. While the
legislative history of the United States Taxpayer Relief Act of 1997 indicates
that the total value of a publicly-traded foreign corporations assets
generally will be treated as equal to the sum of the aggregate value of its
outstanding stock plus its liabilities, there remains substantial uncertainty
regarding the valuation of a publicly-traded foreign corporations assets for
purposes of the asset test, and it is arguable that under alternative valuation
methodologies, the value of our total assets as of the relevant valuation dates
in 2001 and/or 2002 would not result in our classification as a PFIC during
either or both of such years.

In
addition, there can be no assurance that we will not be a PFIC in 2003 or a
later year.  If, for example, the
passive income earned by us exceeds 75% or more of our gross income, we
will be a PFIC under the income test. 
Passive income for PFIC purposes includes, among other things, gross
interest, dividends, royalties, rents and annuities.  For manufacturing businesses, gross income for PFIC purposes
should be determined by reducing total sales by the cost of goods sold.  Although not free from doubt, if our cost of
goods sold exceeds our total sales by an amount greater than our passive
income, such that we are treated as if we had no gross income for PFIC purposes,
we believe that we would not be a PFIC as a result of the income test.  This belief is supported by a private letter
ruling issued by the IRS to a company whose circumstances are substantially the
same as ours, although such private letter ruling would not be binding on the
IRS in determining our status.  In
addition, the tests for determining PFIC status are applied annually and it is
difficult to make accurate predictions of future income and assets, which are
relevant to the determination of PFIC status.

55

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In
view of the uncertainty regarding the valuation of our assets for purposes of
the asset test and the complexity of the issues regarding our treatment as a
PFIC for 2001, 2002 and, quite possibly, subsequent years, U.S. Shareholders
are urged to consult their own tax advisors for guidance as to our status as a
PFIC.

If
we were to be a PFIC at any time during a U.S. holders holding period, such
U.S. holder would be required to either: (i) pay an interest charge together
with tax calculated at maximum ordinary income rates on excess distributions,
which is defined to include gain on a sale or other disposition of ordinary
shares, or (ii) so long as the ordinary shares are regularly traded on a
qualifying exchange, elect to recognize as ordinary income each such year the
excess in the fair market value, if any, of its ordinary shares at the end of
the taxable year over such holders adjusted basis in such ordinary shares and,
to the extent of prior inclusions of ordinary income, recognize ordinary loss
for the decrease in value of such ordinary shares (the mark to market
election).  For this purpose, the Nasdaq
National Market is a qualifying exchange.

The
above discussion does not purport to be an official interpretation of the tax
law provisions mentioned therein or to be a comprehensive description of all
tax law provisions which might apply to our securities or to reflect the views
of the Israeli tax authorities, and it is not meant to replace professional
advice in these matters.  The above
discussion is based on current Israeli tax law, which may be changed by future
legislation or reforms. Non-residents should obtain professional tax advice
with respect to the tax consequences under the laws of their countries of
residence of holding or selling our securities.

Documents
on Display

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

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

56

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

Item
11.               Quantitative
and Qualitive Disclosures About Market Risk

Risks

Interest Rate Risks

Our exposure to market
risk for changes in interest rates relates primarily to our cash equivalents
and investment portfolio. We maintain a strict investment policy, which ensures
the safety and preservation of our invested funds by limiting default risk,
market risk and reinvestment risk. Our cash and cash equivalent as of December
31, 2002, consists primarily of demand deposits and money market funds held by
institutions in the United States, Israel, The UK, The Netherlands, Germany,
Japan and France. Due to the nature of our cash and cash equivalents and
short-term investments, we have concluded that we do not have material market
risk exposure.

Foreign Currency Exchange and
Inflation Risks

Since the majority of our
revenues are paid in or linked to U.S. dollars, we believe that inflation and
fluctuations in the NIS/U.S. dollar exchange rate have no material effect on
our revenues. Inflation in Israel and U.S. dollar exchange rate fluctuations,
however, have some influence on our expenses and as a result, on our net
income. The cost of Israel operations, as expressed in U.S. dollars, is
influenced by the extent to which any increase in the rate of inflation in
Israel is not offset, or is offset on a lagging basis, by a devaluation of the
NIS in relation to the U.S. dollar.

Costs not effectively
denominated in United States dollars are translated to United States dollars,
when recorded, at the prevailing exchange rates for the purposes of our
financial statements. Consequently, fluctuations in the rates of exchange
between the dollar and non-dollar currencies will affect our results of
operations. An increase in the value of a particular currency relative to the
dollar will increase the dollar reporting value for transactions, and a
decrease in the value of that currency relative to the dollar will decrease the
dollar reporting value for those transactions. This effect on the dollar
reporting value for transactions is generally only partially offset by the
impact that currency fluctuations may have on costs. We do engage in currency hedging
transactions to offset the risks associated with variations in currency
exchange rates. However, due to the
instability of the foreign currency markets, significant foreign
currency fluctuations and other foreign exchange risks may have a material
adverse effect on our business, financial condition and results of operations.
Since our revenues are generated in United States dollars and currencies other
than NIS, and a substantial portion of our expenses is incurred and will
continue to be incurred in NIS, we are exposed to risk by the amount that the
rate of inflation in Israel exceeds the rate of devaluation of the NIS in
relation to the dollar and other currencies or if the timing of the devaluation
lags behind inflation in Israel.

Equity
Investments

We have investments in
marketable equity securities of publicly traded companies. These investments,
as of December 31, 2002, were considered available-for-sale, with any
unrealized gains or losses deferred as a component of stockholders equity
accumulated other comprehensive income (loss). At December 31, 2002, the fair
market value of these investments was $860,000.

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Together with our US
subsidiary we have committed to invest approximately $8.5 million in Tamir
Fishman Ventures II (Israel) L.P. and in a
Delaware limited partnership related to Tamir Fishman Ventures II LLC.  As of December 31, 2002 we had invested
approximately $3.7 million.  Together with our US subsidiary, as of May 31,
2003 we have invested a total of $4,150,000 in Tamir Fishman
Ventures II (Israel) L.P. and in a Delaware limited partnership related to
Tamir Fishman Ventures II LLC, which represents close to half of our total
commitment.

Item 12.       Descriptions
of Securities Other than Equity Securities

Not Applicable

PART II

Item 13.       Defaults,
Dividend Arrearages and Delinquencies

None.

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

None.

Item
15.               CONTROLS
AND PROCEDURES

An evaluation was
performed under the supervision and with the participation of our management,
including our chief executive officer and chief financial officer, of the
effectiveness of our disclosure controls and procedures (as defined in Rules
13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended).
Based on that evaluation, which was completed within 90 days of the filing date
of this annual report, our chief executive officer and chief financial officer,
concluded that our disclosure controls and procedures were effective though we
are constantly engaged in the process of improving these controls and
procedures. There have been no significant changes in our disclosure controls
or in other factors that could significantly affect disclosure controls
subsequent to the date of the evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

Item 16.       [Reserved]

PART III

Item 17.       Financial
Statements

Not applicable

58

---

---

Item 18.       Financial
Statements

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

Item
19.               Exhibits

|1.1  | Articles of Association of the registrant, approved
  by shareholders on August 15, 1993.(1)                                        
|---- | ------------------------------------------------------------------------------------------------------------------------------------
|     |                                                                                                                                     
|1.2  | Memorandum of Association of the registrant.(1)(2)                                                                                  
|     |                                                                                                                                     
|2.1  | Form of loan agreement between the registrant and
  certain of its officers and directors. (3)                                      
|     |                                                                                                                                     
|4.1  | Asset Purchase Agreement dated as of May 17, 2001,
  by and between Preview Systems Inc. and the registrant. (3)                    
|     |                                                                                                                                     
|4.2  | Strategic Investor Agreement dated as of February
  21, 2000, by and between the registrant and Tamir Fishman Ventures. (3)         
|     |                                                                                                                                     
|4.3  | Subscription by Aladdin for partnership units in
  Tamir Fishman Ventures. (3)                                                      
|     |                                                                                                                                     
|4.4  | Share Purchase Agreement dated as of February 22,
  2001, by and between the registrant and Tamir Fishman Venture Capital Ltd.
  (3)
|     |                                                                                                                                     
|8.1  | List of subsidiaries.                                                                                                               
|     |                                                                                                                                     
|12.1 | Consent letters from Kost, Forer & Gabbay and Blick Rothenberg.                                                                     
|     |                                                                                                                                     
|12.2 | Certification by Chief Executive Officer pursuant to
  section 906 of the Sarbanes-Oxley Act of 2002.                               
|     |                                                                                                                                     
|12.3 | Certification by Chief Financial Officer pursuant to
  section 906 of the Sarbanes-Oxley Act of 2002.                               

---

|(1) | 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.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                         
|(2) | English translation or summary
  from Hebrew original.                                                                                                  
|    |                                                                                                                                                         
|(3) | Incorporated by reference from
  our 2000 20-F filed with the Securities Exchange Commission on June
  30, 2001.                                        

59

---

---

SIGNATURES

Pursuant to the
requirements of Section 12 of the Securities Exchange Act of 1934, the
registrant certifies that it meets all the requirements for filing on Form 20-F
and has duly caused and authorized the undersigned to sign this annual report
on its behalf in the City of Tel Aviv, State of Israel, on this 30th day of
June 2003.

| | ALADDIN
  KNOWLEDGE SYSTEMS LTD.
| | --------------------------------
|
| | By:                             
| |                                 
| | Yanki Margalit                  
| |                                 
| | Chief Executive Officer and     
| |                                 
| | Chairman of the Board           
| |                                 

60

---

---

CERTIFICATIONS

I, Yanki Margalit,
certify that:

1.    I
have reviewed this annual report on Form 20-F of Aladdin Knowledge Systems
Ltd.;

2.    Based
on my knowledge, this annual report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this annual report;

3.    Based
on my knowledge, the financial statements, and other financial information
included in this annual report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this annual report;

4.    The
registrants other certifying officers and I are responsible for establishing
and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and have:

| | a)  designed such disclosure controls and
  procedures to ensure that material information relating to the registrant,
  including its consolidated subsidiaries, is made known to us by others within
  those entities, particularly during the period in which this annual report is
  being prepared;
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                         
| | b)  evaluated the effectiveness of the
  registrants disclosure controls and procedures as of a date within 90 days
  prior to the filing date of this annual report (the Evaluation Date); and                                                                                                      
| |                                                                                                                                                                                                                                                                                                         
| | c)  presented in this annual report our
  conclusions about the effectiveness of the disclosure controls and procedures
  based on our evaluation as of the Evaluation Date;                                                                                                                            

5.    The
registrants other certifying officers and I have disclosed, based on our most
recent evaluation, to the registrants auditors and the audit committee of
registrants board of directors (or persons performing the equivalent
function):

| | a)  all significant deficiencies in the
  design or operation of internal controls which could adversely affect the
  registrants ability to record, process, summarize and report financial data
  and have identified for the registrants auditors any material weaknesses in
  internal controls; and
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                           
| | b)  any fraud, whether or not material,
  that involves management or other employees who have a significant role in
  the registrants internal controls; and                                                                                                                                            

6.    The
registrants other certifying officers and I have indicated in this annual
report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

|June 30, 2003 | /s/ Yanki Margalit        | 
|------------- | ------------------------- | 
|              |                           | 
|              | Yanki Margalit            | 
|              | Chief
  Executive Officer | 

61

---

---

CERTIFICATIONS

I, Erez Rosen, certify
that:

1.    I
have reviewed this annual report on Form 20-F of Aladdin Knowledge Systems
Ltd.;

2.    Based
on my knowledge, this annual report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this annual report;

3.    Based
on my knowledge, the financial statements, and other financial information
included in this annual report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this annual report;

4.    The
registrants other certifying officers and I are responsible for establishing
and maintaining disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and have:

| | a)  designed such disclosure controls and
  procedures to ensure that material information relating to the registrant,
  including its consolidated subsidiaries, is made known to us by others within
  those entities, particularly during the period in which this annual report is
  being prepared;
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                         
| | b)  evaluated the effectiveness of the
  registrants disclosure controls and procedures as of a date within 90 days
  prior to the filing date of this annual report (the Evaluation Date); and                                                                                                      
| |                                                                                                                                                                                                                                                                                                         
| | c)  presented in this annual report our
  conclusions about the effectiveness of the disclosure controls and procedures
  based on our evaluation as of the Evaluation Date;                                                                                                                            

5.    The
registrants other certifying officers and I have disclosed, based on our most
recent evaluation, to the registrants auditors and the audit committee of
registrants board of directors (or persons performing the equivalent
function):

| | a)  all significant deficiencies in the
  design or operation of internal controls which could adversely affect the
  registrants ability to record, process, summarize and report financial data
  and have identified for the registrants auditors any material weaknesses in
  internal controls; and
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                           
| | b)  any fraud, whether or not material,
  that involves management or other employees who have a significant role in
  the registrants internal controls; and                                                                                                                                            

6.    The
registrants other certifying officers and I have indicated in this annual
report whether or not there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

|June 30, 2003 | /s/ Erez Rosen          | 
|------------- | ----------------------- | 
|              |                         | 
|              | Erez Rosen              | 
|              | Chief Financial Officer | 

62

---

---

ALADDIN KNOWLEDGE SYSTEMS
LTD. AND ITS SUBSIDIARIES

CONSOLIDATED FINANCIAL
STATEMENTS

AS OF DECEMBER 31, 2002

IN U.S.
DOLLARS

INDEX

|                                                    | Page         
|--------------------------------------------------- | -------------
|                                                    |              
|                                                    |              
|Report of Independent
      Auditors                | 2            
|                                                    |              
|Consolidated Balance
      Sheets                   | 3 -
    4    
|                                                    |              
|Consolidated Statements of
      Operations         | 5            
|                                                    |              
|Statements of Changes in Shareholders
      Equity | 6            
|                                                    |              
|Consolidated Statements of Cash
      Flows         | 7 -
    9    
|                                                    |              
|Notes to Consolidated Financial
      Statements    | 10 -
      36

-  -  - 
-  -  -  -  -

---

---

|ERNST
&YOUNG |  | 
|------------ |  | 

REPORT OF INDEPENDENT
AUDITORS

To the shareholders
of

ALADDIN KNOWLEDGE SYSTEMS
LTD.

We have
audited the accompanying consolidated balance sheets of Aladdin Knowledge
Systems Ltd. (the Company), and its subsidiaries as of December 31, 2001 and
2002, and the related consolidated statements of operations, changes in
shareholders equity and cash flows for each of the three years in the period
ended December 31, 2002. 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 Knowledge Systems Western Europe Ltd.,
a wholly-owned U.K. subsidiary, which statements reflect total assets
constituting 4% and 5% as of December 31, 2001 and 2002, respectively, and total
revenues constituting 6%, 6% and 7% of the related consolidated revenues for the
years ended December 31, 2000, 2001 and 2002, respectively. Those statements
were audited by other auditors whose report has been furnished to us, and our
opinion, insofar as it relates to the data included for Aladdin Knowledge
Systems Western Europe Ltd., is based solely on the report of the other
auditors.

We conducted
our audits in accordance with auditing standards generally accepted in the
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 the other auditors
provide a reasonable basis for our opinion.

In our
opinion, based on our audits and the report of the 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, 2001 and 2002, and the consolidated results of
their operations and cash flows for each of the three years in the period ended
December 31, 2002, in conformity with accounting principles generally accepted
in the United States.

As discussed
in Note 2 to the consolidated financial statements, the Company adopted the full
provisions of Statement of Financial Accounting Standards No. 142 Goodwill and
Other Intangible Assets, effective January 1, 2002.

|Tel-Aviv, Israel | KOST FORER &
      GABBAY             
|---------------- | --------------------------------------
|February 5, 2003 | A Member of Ernst
      & Young Global

- 2 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.
|------------------------------------
|AND ITS
  SUBSIDIARIES              
|CONSOLIDATED BALANCE
      SHEETS   
|                                    
|U.S. dollars in thousands           

|                                           |                                                                                                               | December
      31, |       
|------------------------------------------ | ------------------------------------------------------------------------------------------------------------- | ------------------ | ------
|                                           |                                                                                                               |                    |       
|                                           |                                                                                                               | 2001               |       
|                                           |                                                                                                               |                    |       
|ASSETS                                     |                                                                                                               |                    |       
|                                           |                                                                                                               |                    |       
|CURRENT ASSETS:                            |                                                                                                               |                    |       
|                                           | Cash and cash equivalents                                                                                     |                    | $     
|                                           | Marketable securities (Note
    3)                                                                            |                    |       
|                                           | Trade receivables (net of allowance for
      doubtful accounts - $ 1,525    in 2001 and $ 991 in
      2002) |                    |       
|                                           | Other accounts receivable and prepaid
      expenses (Note 4)                                                 |                    |       
|                                           | Deferred income taxes (Note
    13)                                                                           |                    |       
|                                           | Inventories (Note 5)                                                                                          |                    |       
|                                           |                                                                                                               |                    |       
|                                           |                                                                                                               |                    |       
|Total current assets                       |                                                                                                               |                    | 33,011
|                                           |                                                                                                               |                    |       
|                                           |                                                                                                               |                    |       
|LONG-TERM INVESTMENTS:                     |                                                                                                               |                    |       
|                                           | Investment in affiliate (Note
    6)                                                                          |                    |       
|                                           | Investment in other company (Note
      7)                                                                    |                    |       
|                                           | Severance pay fund                                                                                            |                    |       
|                                           |                                                                                                               |                    |       
|                                           |                                                                                                               |                    |       
|Total long-term investments                |                                                                                                               |                    | 4,577 
|                                           |                                                                                                               |                    |       
|                                           |                                                                                                               |                    |       
|PROPERTY AND EQUIPMENT, NET (Note
      8) |                                                                                                               |                    | 4,456 
|                                           |                                                                                                               |                    |       
|                                           |                                                                                                               |                    |       
|OTHER ASSETS, NET                          |                                                                                                               |                    |       
|                                           | Intangible assets, net (Note
    9)                                                                           |                    |       
|                                           | Goodwill (Note 10)                                                                                            |                    |       
|                                           | Deferred income taxes (Note
    13)                                                                           |                    |       
|                                           |                                                                                                               |                    |       
|                                           |                                                                                                               |                    |       
|                                           | Total other assets                                                                                            |                    |       
|                                           |                                                                                                               |                    |       
|                                           |                                                                                                               |                    |       
|Total assets                               |                                                                                                               | $                  | 53,395
|                                           |                                                                                                               |                    |       

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

- 3 -

---

---

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

|                                                       |                                                                                                                                                                                                                                                                                    | December
      31, |       
|------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------ | ------
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    | 2001               |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|LIABILITIES AND SHAREHOLDERS
      EQUITY             |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|CURRENT LIABILITIES:                                   |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       | Trade payables                                                                                                                                                                                                                                                                     |                    | $     
|                                                       | Income taxes payable                                                                                                                                                                                                                                                               |                    |       
|                                                       | Deferred revenues                                                                                                                                                                                                                                                                  |                    |       
|                                                       | Accrued expenses and other accounts payable
      (Note 11)                                                                                                                                                                                                                        |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|Total current liabilities                              |                                                                                                                                                                                                                                                                                    |                    | 8,362 
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|ACCRUED SEVERANCE PAY                                  |                                                                                                                                                                                                                                                                                    |                    | 2,404 
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|COMMITMENTS AND CONTINGENT LIABILITIES (Note
      12) |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|SHAREHOLDERS EQUITY (Note
    14):                    |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       | Share capital: Ordinary shares - NIS 0.01
      par value; Authorized -    15,000,000 shares at
      December 31, 2001 and 2002; Issued -
          11,477,922 shares at December 31, 2001 and
      2002; Outstanding -    11,253,822 shares at
      December 31, 2001 and 2002 |                    |       
|                                                       | Additional paid-in capital                                                                                                                                                                                                                                                         |                    |       
|                                                       | Treasury shares                                                                                                                                                                                                                                                                    |                    |       
|                                                       | Accumulated other comprehensive
      loss                                                                                                                                                                                                                                         |                    |       
|                                                       | Retained earnings                                                                                                                                                                                                                                                                  |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|Total shareholders equity                             |                                                                                                                                                                                                                                                                                    |                    | 42,629
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       
|Total liabilities and shareholders
      equity       |                                                                                                                                                                                                                                                                                    | $                  | 53,395
|                                                       |                                                                                                                                                                                                                                                                                    |                    |       

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

- 4 -

---

---

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

|                                                            |                                     | Year
      endedDecember 31, |       
|----------------------------------------------------------- | ----------------------------------- | ---------------------------- | ------
|                                                            |                                     |                              |       
|                                                            |                                     | 2000                         |       
|                                                            |                                     |                              |       
|Revenues (Note 16):                                         |                                     |                              |       
|Product sales                                               |                                     | $                            | 38,134
|Software sales and other                                    |                                     |                              | 6,211 
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Total revenues                                              |                                     |                              | 44,345
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Cost of revenues:                                           |                                     |                              |       
|                                                            | Product sales                       |                              |       
|                                                            | Software sales and other            |                              |       
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Total cost of revenues                                      |                                     |                              | 10,645
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Gross profit                                                |                                     |                              | 33,700
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Operating expenses:                                         |                                     |                              |       
|                                                            | Research and development            |                              |       
|                                                            | Selling and marketing               |                              |       
|                                                            | General and administrative          |                              |       
|                                                            | Impairment of intangible
    assets |                              |       
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Total operating expenses                                    |                                     |                              | 37,201
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Operating loss                                              |                                     |                              | (3,501
|Financial income (expenses), net (Note
      17a)           |                                     |                              | 1,421 
|Other income (expenses), net (Note
      17b)               |                                     |                              | 5,483 
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Income (loss) before taxes on
      income                  |                                     |                              | 3,403 
|Taxes on income (Note 13)                                   |                                     |                              | 1,640 
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Income (loss) before equity in losses of an
      affiliate |                                     |                              | 1,763 
|Equity in losses of an
    affiliate                        |                                     |                              | (323  
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Net income (loss)                                           |                                     | $                            | 1,440 
|                                                            |                                     |                              |       
|Net earnings (loss) per share (Note
      17c):             |                                     |                              |       
|Basic                                                       |                                     | $                            | 0.13  
|                                                            |                                     |                              |       
|                                                            |                                     |                              |       
|Diluted                                                     |                                     | $                            | 0.12  
|                                                            |                                     |                              |       

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

- 5 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.               
|---------------------------------------------------
|AND ITS
  SUBSIDIARIES                             
|STATEMENTS OF CHANGES IN SHAREHOLDERS
      EQUITY
|                                                   
|U.S. dollars in
    thousands                      

|                                                                                                |                                                                                                                                      | Sharecapital |    | Additionalpaid-incapital |  | Treasuryshares |        | Accumulatedothercomprehensiveincome
      (loss) |  | Retainedearnings |        | Totalcomprehensiveloss |   | Totalshareholdersequity |       
|----------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------ | ------------ | -- | ------------------------ |  | -------------- | ------ | ------------------------------------------------ |  | ---------------- | ------ | ---------------------- | - | ------------------------ | ------
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|Balance as of January 1,
2000                                                                   |                                                                                                                                      | $            | 37 |                          |  | $              | 35,543 |                                                  |  | $                | (506   | )                      |   | $                        | 39    
|                                                                                                | Purchase of Treasury shares                                                                                                          |              |    | -                        |  |                |        | -                                                |  |                  |        | (903                   | ) |                          |       
|                                                                                                | Exercise of stock options                                                                                                            |              |    | -                        |  |                |        | 604                                              |  |                  |        | 506                    |   |                          |       
|                                                                                                | Comprehensive loss:                                                                                                                  |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Unrealized losses from available-for-sale
      marketable securities, net of taxes                                                  |              |    | -                        |  |                |        | -                                                |  |                  |        | -                      |   |                          |       
|                                                                                                | Foreign currency translation
      adjustments                                                                                       |              |    | -                        |  |                |        | -                                                |  |                  |        | -                      |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Total other comprehensive
    loss                                                                                                   |              |    | -                        |  |                |        | -                                                |  |                  |        | -                      |   |                          |       
|                                                                                                | Net income                                                                                                                           |              |    | -                        |  |                |        | -                                                |  |                  |        | -                      |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Total comprehensive loss                                                                                                             |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|Balance as of December 31,
    2000                                                             |                                                                                                                                      |              | 37 |                          |  |                | 36,147 |                                                  |  |                  | (903   | )                      |   |                          | (3,972
|                                                                                                | Purchase of Treasury shares                                                                                                          |              |    | -                        |  |                |        | -                                                |  |                  |        | (261                   | ) |                          |       
|                                                                                                | Other comprehensive loss:                                                                                                            |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Unrealized losses on available-for-sale
      marketable securities, net of taxes                                                    |              |    | -                        |  |                |        | -                                                |  |                  |        | -                      |   |                          |       
|                                                                                                | Less - reclassificating adjustment of other
      than temporary decrease in value of available-for-sale marketable
      securities |              |    | -                        |  |                |        | -                                                |  |                  |        | -                      |   |                          |       
|                                                                                                | Foreign currency translation
      adjustments                                                                                       |              |    | -                        |  |                |        | -                                                |  |                  |        | -                      |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Total other comprehensive
    loss                                                                                                   |              |    | -                        |  |                |        | -                                                |  |                  |        | -                      |   |                          |       
|                                                                                                | Net loss                                                                                                                             |              |    | -                        |  |                |        | -                                                |  |                  |        | -                      |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Total comprehensive loss                                                                                                             |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|Balance as of December 31,
    2001                                                             |                                                                                                                                      |              | 37 |                          |  |                | 36,147 |                                                  |  |                  | (1,164 | )                      |   |                          | (4,863
|                                                                                                | Other comprehensive loss:                                                                                                            |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Unrealized losses on available-for-sale
      marketable securities, net of taxes                                                    |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Less - reclassificating adjustment of other
      than temporary decrease in value of available-for-sale marketable
      securities |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Foreign currency translation
      adjustments                                                                                       |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Total other comprehensive
    income                                                                                                 |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Net loss                                                                                                                             |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                | Total comprehensive loss                                                                                                             |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|Balance as of December 31,
    2002                                                             |                                                                                                                                      | $            | 37 |                          |  | $              | 36,147 |                                                  |  | $                | (1,164 | )                      |   | $                        | (4,529
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|Accumulated unrealized losses from
      available-for-sale marketable securities, net of taxes |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   | $                        | (67   
|Accumulated foreign currency translation
      adjustments                                      |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          | (4,462
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       
|Accumulated other comprehensive
      loss                                                      |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   | $                        | (4,529
|                                                                                                |                                                                                                                                      |              |    |                          |  |                |        |                                                  |  |                  |        |                        |   |                          |       

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

- 6 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.       
|-------------------------------------------
|AND ITS
  SUBSIDIARIES                     
|CONSOLIDATED STATEMENTS OF CASH
      FLOWS
|                                           
|U.S. dollars in
    thousands              

|                                                                                                                         |                                                                                | Year
      endedDecember 31, |       
|------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------------------------------------------ | ---------------------------- | ------
|                                                                                                                         |                                                                                |                              |       
|                                                                                                                         |                                                                                | 2000                         |       
|                                                                                                                         |                                                                                |                              |       
|Cash flows from operating
      activities:                                                                              |                                                                                |                              |       
|                                                                                                                         |                                                                                |                              |       
|Net income (loss)                                                                                                        |                                                                                | $                            | 1,440 
|Adjustments required to reconcile net income
      (loss) to net  cash provided by (used in)
      operating activities: |                                                                                |                              |       
|                                                                                                                         | Depreciation and
amortization                                                  |                              |       
|                                                                                                                         | Impairment of intangible
    assets                                            |                              |       
|                                                                                                                         | Impairment of investment in an
      affiliate                                 |                              |       
|                                                                                                                         | Equity in losses of an
    affiliate                                           |                              |       
|                                                                                                                         | Impairment of investment in other
      company                                |                              |       
|                                                                                                                         | Increase (decrease) in accrued severance
      pay, net                        |                              |       
|                                                                                                                         | Impairment of marketable
      securities                                      |                              |       
|                                                                                                                         | Gain on sale of available for sale
      marketable securities                 |                              |       
|                                                                                                                         | Loss (gain) on sale of property and
      equipment                            |                              |       
|                                                                                                                         | Deferred income taxes, net                                                     |                              |       
|                                                                                                                         | Decrease (increase) in trade
      receivables                                 |                              |       
|                                                                                                                         | Decrease (increase) in
      inventories                                       |                              |       
|                                                                                                                         | Decrease (increase) in other accounts
      receivable and prepaid    expenses |                              |       
|                                                                                                                         | Increase (decrease) in trade
      payables                                    |                              |       
|                                                                                                                         | Decrease in income taxes
    payable                                           |                              |       
|                                                                                                                         | Increase in deferred
revenues                                                  |                              |       
|                                                                                                                         | Increase (decrease) in accrued expenses and
      other accounts    payable    |                              |       
|                                                                                                                         | Other                                                                          |                              |       
|                                                                                                                         |                                                                                |                              |       
|                                                                                                                         |                                                                                |                              |       
|Net cash provided by (used in) operating
      activities                                                                |                                                                                |                              | (2,368
|                                                                                                                         |                                                                                |                              |       

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

- 7 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.       
|-------------------------------------------
|AND ITS
  SUBSIDIARIES                     
|CONSOLIDATED STATEMENTS OF CASH
      FLOWS
|                                           
|U.S. dollars in
    thousands              

|                                                             |                                                                      | Year
      endedDecember 31, |        
|------------------------------------------------------------ | -------------------------------------------------------------------- | ---------------------------- | -------
|                                                             |                                                                      |                              |        
|                                                             |                                                                      | 2000                         |        
|                                                             |                                                                      |                              |        
|Cash flows from investing
      activities:                  |                                                                      |                              |        
|                                                             |                                                                      |                              |        
|                                                             | Investment in short-term bank
      deposits                         |                              | $      
|                                                             | Proceeds from short-term bank
      deposits                         |                              |        
|                                                             | Investment in available-for-sale marketable
      securities         |                              |        
|                                                             | Proceeds from sale of available-for-sale
      marketable securities |                              |        
|                                                             | Investment in shares and long-term loan of
      an affiliate        |                              |        
|                                                             | Proceeds from long-term loan to an
      affiliate                   |                              |        
|                                                             | Purchase of property and
      equipment                             |                              |        
|                                                             | Proceeds from sale of property and
      equipment                   |                              |        
|                                                             | Purchase of intangible
assets                                        |                              |        
|                                                             | Investment in other company                                          |                              |        
|                                                             | Payment for the purchase of Aladdin France
      and CTI (1)         |                              |        
|                                                             | Payment for the purchase of Preview
      (2)                        |                              |        
|                                                             |                                                                      |                              |        
|                                                             |                                                                      |                              |        
|Net cash provided by (used in) investing
      activities    |                                                                      |                              | (13,806
|                                                             |                                                                      |                              |        
|                                                             |                                                                      |                              |        
|Cash flows from financing
      activities:                  |                                                                      |                              |        
|                                                             |                                                                      |                              |        
|                                                             | Short-term bank credit, net                                          |                              |        
|                                                             | Proceeds from exercise of
      options                              |                              |        
|                                                             | Purchase of treasury shares                                          |                              |        
|                                                             |                                                                      |                              |        
|                                                             |                                                                      |                              |        
|Net cash provided by (used in) financing
      activities    |                                                                      |                              | 157    
|                                                             |                                                                      |                              |        
|                                                             |                                                                      |                              |        
|Effect of exchange rate on cash and cash
      equivalents   |                                                                      |                              | 13     
|                                                             |                                                                      |                              |        
|                                                             |                                                                      |                              |        
|Increase (decrease) in cash and cash
      equivalents       |                                                                      |                              | (16,004
|Cash and cash equivalents at the beginning
      of the year |                                                                      |                              | 30,349 
|                                                             |                                                                      |                              |        
|                                                             |                                                                      |                              |        
|Cash and cash equivalents at the end of the
      year       |                                                                      | $                            | 14,345 
|                                                             |                                                                      |                              |        

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

- 8 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.       
|-------------------------------------------
|AND ITS
  SUBSIDIARIES                     
|CONSOLIDATED STATEMENTS OF CASH
      FLOWS
|                                           
|U.S. dollars in
    thousands              

|                                                                                                                           |                                                                                                                  | Year
      endedDecember 31, |    
|-------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------- | ---------------------------- | ---
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  | 2000                         |    
|                                                                                                                           |                                                                                                                  |                              |    
|Supplemental
    disclosure:                                                                                               |                                                                                                                  |                              |    
|                                                                                                                           | Interest paid during the
year                                                                                    |                              | $  
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           | Income taxes paid during the
      year                                                                          |                              | $  
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|Non-cash activities:                                                                                                       |                                                                                                                  |                              |    
|                                                                                                                           | Conversion of long-term note receivable to
      an investment in an    affiliate                                |                              | $  
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           | Waiver of employee loans in exchange for
      investment in    Tamir Fishman Venture II
      Ltd.              |                              | $  
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           | Conversion of balance in trade receivable
      due from an    affiliate to long-term loan to an
      affiliate |                              | $  
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|(1) Payment for the purchase of Aladdin
      France and Commerce    Technology International
      (CTI) (see Note 1c): |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           | Fair value of assets acquired and
      liabilities assumed at the    date of
      acquisition:                 |                              |    
|                                                                                                                           | Working capital deficiency (excluding cash
      and cash    equivalents)                                        |                              | $  
|                                                                                                                           | Property and equipment                                                                                           |                              |    
|                                                                                                                           | Other assets                                                                                                     |                              |    
|                                                                                                                           | Goodwill                                                                                                         |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  | $                            | 854
|                                                                                                                           |                                                                                                                  |                              |    
|(2) Payment for purchase of Preview (see
      Note 1b):                                                                   |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           | Fair value of assets acquired and
      liabilities assumed at the date    of
      acquisition:                 |                              |    
|                                                                                                                           | Trade receivable                                                                                                 |                              |    
|                                                                                                                           | Property and equipment                                                                                           |                              |    
|                                                                                                                           | Liabilities assumed in respect of expected
      costs                                                           |                              |    
|                                                                                                                           | Intangible assets - current
      technology                                                                     |                              |    
|                                                                                                                           | Goodwill                                                                                                         |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    
|                                                                                                                           |                                                                                                                  |                              |    

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

- 9 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 1:- | GENERAL
|-------- | -------
|         |        
|         | a.     
|         |        
|         |        
|         |        
|         | b.     
|         |        
|         |        
|         |        
|         |        
|         |        
|         |        
|         |        
|         |        
|         |        
|         |        

| | Trade receivable       |  | $ | 339   | 
| | ---------------------- |  | - | ----- | 
| | Property and equipment |  |   | 662   | 
| | Goodwill               |  |   | 3,393 | 
| | Current Technology     |  |   | 1,039 | 
| |                        |  |   |       | 
| |                        |  |   |       | 
| | Net assets acquired    |  | $ | 5,433 | 
| |                        |  |   |       | 

| |  | Pro forma information, in
      accordance with SFAS No. 141, has not been provided, since the revenues
      and net loss of Preview for 2000 and 2001, were not material, in relation
      to total consolidated revenues and net income
  (loss).
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

- 10 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 1:- | GENERAL (cont.)
|-------- | ---------------
|         |                
|         | c.             
|         |                
|         |                
|         |                
|         |                
|         |                
|         |                
|         |                
|         |                
|         |                
|         | d.             
|         |                
|         |                
|         |                
|         |                

| |                               |  | Year
      endedDecember 31,2002
| | ----------------------------- |  | --------------------------------
| |                               |  |                                 
| |                               |  |                                 
| | Employee termination
benefits |  |                                 
| | Facilities closures           |  |                                 
| | Consulting fees               |  |                                 
| | Other                         |  |                                 
| |                               |  |                                 
| |                               |  |                                 
| |                               |  | $                               
| |                               |  |                                 

- 11 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING
      POLICIES                                                                                                                                                                                                                                                                                                                                                                                                      
|-------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | The consolidated financial statements have
      been prepared in accordance with accounting principles generally accepted
      in the United States (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 those estimates.                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | Financial statements in United States
      dollars:                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | 1.                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | 2.                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | 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 equivalents:                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | Cash equivalents include short-term, highly
      liquid investments that are readily convertible to cash with original
      maturities of three months or less.                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | Marketable
  securities:                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | Management determines the appropriate
      classification of its investments in equity securities at the time of
      purchase and reevaluates such determinations at each balance sheet date.
      All marketable securities covered by Statement of Financial Accounting
      Standard No. 115 Accounting for certain Investments in Debt and Equity
      Securities (SFAS No. 115) were designated as
      available-for-sale.

- 12 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES
      (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Accordingly, the Companys
      available-for-sale securities are stated at fair value, with unrealized
      gains and losses reported in a separate component of accumulated other
      comprehensive income (loss) in shareholders equity. 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, as financial income (expenses), as
      appropriate.                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | According Staff Accounting Bulletin No. 59
      (SAB No. 59) management is required to evaluate in each period whether a
      securities decline in value is other than temporary. The Stock Exchange
      Committee (SEC) considers fair value below cost for two consecutive
      quarters to be other than temporary impairment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The Companys available-for-sale securities
      declines were included in the consolidated statements of operations as
      financial expenses (see Notes 3 and 17b).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Investment in an
      affiliate:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The investment in an affiliate over which
      the Company can exercise significant influence (generally, entities in
      which the Company holds 20% to 50% of ownership or voting rights) is
      presented using the equity method of accounting, and in accordance with
      EITF 99-10, Percentage Used to Determine the Amount of Equity Method
      Losses, which requires that an investor should recognize equity method
      losses based on the ownership level of the particular investee security
      held by the investor or the change in the investors claim on the
      investees book value. The Company generally discontinues applying the
      equity method when its investment (including advances and loans) is
      reduced to zero and it has not guaranteed obligations of the affiliate or
      otherwise committed to provide further financial support to the affiliate.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The investments are reviewed for impairment
      whenever events or changes in circumstances indicate that the carrying
      amount of an investment may not be recoverable in accordance with
      Accounting Principle Board Opinion No.18 The Equity Method of Accounting
      for Investments in Common Stock, (APB No.18).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | As of December 31, 2002, based on
      managements most recent analyses, impairment losses have been identified
      in the amount of $291, and have been included in equity losses of an
      affiliate. (see Note 6).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

| | Investment in Other
      Company:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | The investment in this company is stated at
      cost, since the Company does not have the ability to exercise significant
      influence over operating and financial policies of the investee. The
      Companys investment in the other company 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 APB
      No.18. As of December 31, 2002 and 2001 based on managements most recent
      analyses, impairment losses have been identified in the amount of $ 1,038 and $ 3,350, respectively.
      (see Note 7 and 15).

- 13 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES
      (Cont.)                                                                                                                                                                                                       
|-------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                     
|         | Inventories:                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                     
|         | Inventories are stated at the lower of cost
      or market value. Inventory write-offs are provided to cover risks arising
      from slow-moving items, excess inventories, technological obsolescence or
      for market prices lower than cost.
|         |                                                                                                                                                                                                                                                     
|         | Cost is determined as
    follows:                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                     
|         | Raw materials, parts and supplies - using
      the moving average cost method.                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                     
|         | Work-in-progress - represents the cost of
      manufacturing.                                                                                                                                                                                      
|         |                                                                                                                                                                                                                                                     
|         | Finished products - recorded on the basis of
      direct manufacturing costs and related overhead.                                                                                                                                                 
|         |                                                                                                                                                                                                                                                     
|         | 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 | 15 -
  33                       
| | Office furniture and
    equipment       | 6 -
20                          
| | Motor vehicles                           | 15                              
| | Leasehold improvements                   | Over the term of the
      lease

| | Intangible assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | Intangible assets acquired in a business
      combination for which date is on or after July 1, 2001, should be
      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 Statement of
      Financial Accounting Standards No. 142 Goodwill and Other Intangible
      Assets, (SFAS No. 142).
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | Current technology is amortized using the
      straight-line method over its estimated useful life which is five
      year.                                                                                                                                                                                                                                                                                                                                       

- 14 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES
      (cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         | Impairment of long-lived assets and
      identifiable intangibles:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         | The Company and its subsidiaries long-lived
      assets and certain identifiable intangibles 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) and in accordance with Statement of Financial Accounting Standard
      No. 121 Accounting for the Impairment of Long-Lived Assets and for the
      Long-lived Assets to be Disposed Of (SFAS No. 121). SFAS No. 121
      related only to the years 2000 and 2001 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. As of December 31, 2002, no impairment losses have
      been identified.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         | Goodwill:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         | Goodwill represents excess of the costs over
      the fair value of net assets of businesses acquired. Goodwill that arose
      from acquisitions prior to July 1, 2001, was amortized until December 31,
      2001, on a straight-line basis over 5-10 years. Under SFAS No. 142
      goodwill acquired in a business combination for which date is on or after
      July 1, 2001, shall not be amortized.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         | SFAS No.142 requires goodwill to be tested
      for impairment on adoption and at least annually thereafter or between
      annual tests in certain circumstances, and written down when impaired,
      rather than being amortized as previous accounting standards required.
      Goodwill is tested for impairment by comparing the fair value of the
      reporting unit with its carrying value. Fair value is determined using the
      income approach. Significant  estimates  used in the  methodologies  included  estimates of future cash flows and  estimates of
discount rate. The Company has performed the annual impairment tests during the
      fourth fiscal quarter. As of December 31, 2002, no impairment losses have
      been identified.                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         | In the third quarter of 2001, management
      considered current and anticipated industry conditions, recent changes in
      its business strategies and current and anticipated operating results. As
      a result of the above conditions, management conducted an evaluation of
      the carrying value and amortization periods of the Companys recorded
      Goodwill. The evaluation resulted in an impairment charge of
      $ 5,211. The evaluation was in accordance of SFAS 121.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         | 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 their estimated realizable
      value.                                                                                                                                                                                                                                                                                                                                                                                                                                        

- 15 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES
      (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | Research and development
      costs:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | SFAS 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 the completion of a
      working model. The Company generally does not incur any costs between the
      completion of the working model and the point at which the product is
      ready for general release. Therefore, through December 31, 2002, the
      Company has charged all software development costs and research and
      development costs in the period in which they were
    incurred.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | Revenue
  recognition:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | The Company generates revenues from
      licensing the rights to use their software products directly to end-users
      and indirectly through resellers (both of whom are considered end users),
      from the sale of products, maintenance and updates.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | The Companys products are generally a
      bundled hardware and software solution that are delivered together.
      Revenues from products are recognized in accordance with Staff Accounting
      Bulletin No. 101 Revenue Recognition in Financial Statements (SAB No.
      101) when the following criteria are met: persuasive evidence of an
      arrangement exists, delivery of the product has occurred, the fee is fixed
      or determinable and collectibility is probable. The Company has no
      obligation to customers after the date in which products are
      delivered.                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | Revenues from software license agreements
      are recognized, in accordance with Statement Of Position 97-2, Software
      Revenue Recognition (SOP No. 97-2), as amended, upon delivery of the
      software, when collectibility is probable, the license fee is fixed or
      determinable, vendor-specific objective evidence (VSOE) of fair value
      exists to allocate the total fee to undelivered elements of the
      arrangement, persuasive evidence of an arrangement exists and no further
      significant obligation remains.                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | Where software arrangements involve multiple
      elements, revenues are allocated to each element based on VSOE of the
      relative fair values of each element in the arrangement in accordance with
      the residual method prescribed by Statement of Position No. 98-9
      Modification of SOP 97-2, Software Revenue Recognition with Respect to
      Certain Transactions (SOP No. 98-9). The Companys VSOE used to
      allocate the sales price to updates and maintenance is based on the price
      charged when these elements are sold separately. License revenues are
      recorded based on the residual method. Under the residual method, revenues
      are recognized for the delivered elements when (1) there is VSOE of the
      fair values of all the undelivered elements and (2) all revenue
      recognition criteria of SOP No. 97-2, as amended, are satisfied. Under the
      residual method any discount in the arrangement is allocated to the
      delivered element.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

- 16 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES
      (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Revenues from maintenance and updates are
      recognized over the term of agreement on a straight line 
      basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Deferred revenues include unearned amounts
      received under maintenance contracts, and amounts recorded from customers
      but not yet recognized as revenues.                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Severance pay:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The Companys liability for severance pay is
      calculated pursuant to Israeli severance pay law, based on the most recent
      salary of the Israeli employees, multiplied by the number of years of
      employment as of balance sheet date. Employees are entitled to one months
      salary for each year of employment, or a portion thereof. The Companys
      liability for all of its employees in Israel is fully provided by monthly
      deposits with severance pay funds, insurance policies and by an accrual.
      The value of those policies is recorded as an asset in the Companys
      balance sheet.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The deposited funds include profits
      accumulated up to the balance sheet date. The deposited funds may be
      withdrawn, only upon fulfillment of the obligation pursuant to Israeli
      severance pay law or labor agreements. The value of the deposited funds is
      based on the cash surrendered value of these policies, and includes
      immaterial profits.                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Severance pay expenses for the years ended
      December 31, 2000, 2001 and 2002, amounted to $ 792, $ 991 and $ 1,468,
      respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Advertising
  expenses:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Advertising expenses are charged to the
      statement of operations as incurred. Advertising expenses for the years
      ended December 31, 2000, 2001 and 2002 were $ 3,356, $ 3,467 and $ 3,717,
      respectively.                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Concentrations of credit
      risks:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Financial instruments that potentially
      subject the Company and its subsidiaries to concentrations of credit risk
      consist principally of cash and cash equivalents, marketable securities,
      trade receivables loans to employees, and long-term loan and convertible
      bond of an affiliate company.                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The majority of the Companys cash and cash
      equivalents is invested in U.S. dollar deposits with major banks in
      Israel, the United States, Japan, the Netherlands, the U.K. and France.
      Such deposits in the United States may be in excess of insured limits and
      are not insured in other jurisdictions. 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.                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The trade receivables of the Company and its
      subsidiaries are derived from sales to customers located primarily in the
      U.S., Europe, South East Asia 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.                                                                                                                                 

- 17 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES
      (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The Company and its subsidiaries have no
      significant off-balance sheet concentration of credit risk such as foreign
      exchange contracts, options contracts or other foreign hedging
      arrangements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | Basic and diluted net earnings (loss) per
      share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | Basic net earnings (loss) per share is
      computed based on the weighted average number of Ordinary shares
      outstanding during each year. Diluted net earnings per share are computed
      based on the weighted average number of Ordinary shares outstanding during
      each year, plus dilutive potential Ordinary shares considered outstanding
      during the year, in accordance with Statement of Financial Accounting
      Standard No. 128, Earnings Per Share (SFAS No.
128).                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The total weighted average number of shares
      related to the outstanding options excluded from the calculations of
      diluted net earnings (loss) per share since they had an anti-dilutive
      effect were 149,254, 1,423,041 and 1,543,902 for 2000, 2001 and 2002,
      respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | Accounting for stock-based
      compensation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The Company has elected to follow Accounting
      Principles Board Opinion No. 25, Accounting for Stock Issued to
      Employees (APB No. 25) and FASB Interpretation No. 44 Accounting for
      Certain Transactions Involving Stock Compensation (FIN No. 44), in
      accounting for its employee stock option plans. Under APB No. 25, when the
      exercise price of the Companys stock options is less than the market
      price of the underlying shares on the date of grant, compensation expense
      is recognized.                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | In December 2002, the FASB issued Statement
      of Financial Accounting Standard No. 148, Accounting for Stock Based
      Compensation Transmission and Disclosure - an amendment of FASB Statement
      No. 123 (SFAS No. 148). SFAS No. 148 permits two additional transition
      methods for entities that adopt the fair value based method of accounting
      for stock-based employee compensation. The transition guidance and annual
      disclosure provisions of SFAS No. 148 are effective for fiscal years
      ending after December 15, 2002, with earlier application permitted in
      certain circumstances. The interim disclosure provisions are effective for
      financial reports containing financial statements for interim periods
      beginning after December 15, 2002. As at the balance sheet date, the
      Company continues to apply APB No. 25.

- 18 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES
      (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Under Statement of Financial Accounting
      Standard No. 123 Accounting for Stock-Based Compensation, (SFAS No.
      123), pro forma information regarding net income (loss) and net earnings
      (loss) per share is required, and has been determined as if the Company
      had accounted for its employee stock options under the fair value method
      of that Statement. The fair value for these options was estimated at the
      date of grant using a Black-Scholes option valuation model with the
      following weighted-average assumptions for 2000, 2001 and 2002,
      respectively: risk-free interest rates of 6%, 2% and 1.5%, respectively;
      dividend yields of 0%, for each year; volatility factors of the expected
      market price of the Companys Ordinary shares of 0.751, 0.536 and 0.258,
      respectively, and a weighted average expected life of five years for each
      option. The fair value for options granted is amortized over their vesting
      period.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Pro forma information under SFAS No.
      123:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

| |                                                                                                           |  | Year
      endedDecember 31, |      
| | --------------------------------------------------------------------------------------------------------- |  | ---------------------------- | -----
| |                                                                                                           |  |                              |      
| |                                                                                                           |  | 2000                         |      
| |                                                                                                           |  |                              |      
| | Net income (loss) as
reported                                                                             |  | $                            | 1,440
| |                                                                                                           |  |                              |      
| | Deduct: stock-based compensation expense
      determined    under fair value method for all
      awards |  | $                            | 1,147
| |                                                                                                           |  |                              |      
| |                                                                                                           |  |                              |      
| | Pro forma net income (loss)                                                                               |  | $                            | 293  
| |                                                                                                           |  |                              |      
| |                                                                                                           |  |                              |      
| | Basic net earnings (loss) per share as
      reported                                                     |  | $                            | 0.13 
| |                                                                                                           |  |                              |      
| |                                                                                                           |  |                              |      
| | Diluted net earnings (loss) per share as
      reported                                                   |  | $                            | 0.12 
| |                                                                                                           |  |                              |      
| |                                                                                                           |  |                              |      
| | Pro forma basic net earnings (loss) per
      share                                                       |  | $                            | 0.026
| |                                                                                                           |  |                              |      
| |                                                                                                           |  |                              |      
| | Pro forma diluted net earnings (loss) per
      share                                                     |  | $                            | 0.025
| |                                                                                                           |  |                              |      

| | 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:                                                                          
| |                                                                                                                                                                                                                                                
| | Cash and cash equivalents, trade
      receivables, other accounts receivable, trade payables and other accounts
      payable - the carrying amounts approximate their fair value due to the
      short-term maturity of such instruments.   
| |                                                                                                                                                                                                                                                
| | The fair value of marketable securities is
      based on the quoted market price.                                                                                                                                                             
| |                                                                                                                                                                                                                                                
| | Treasury Shares:                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                
| | The Company repurchases its Ordinary Shares
      from time to time on the open market and holds such shares as treasury
      shares. The Company presents the cost to repurchase treasury stock as a
      reduction of shareholders equity.

- 19 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES
      (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | Reclassification:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | Certain amounts from prior years have been
      reclassified to conform to the current years
  presentation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | The reclassification had no effect on
      previously reported net loss, shareholders equity or cash
      flows.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | Implementation of new accounting
      standards and their impact on the financial
  statements:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | In June 2002, the FASB issues SFAS No. 146,
      Accounting for Costs Associated with Exit or Disposal Activities, which
      addresses significant issue regarding the recognition, measurement, and
      reporting of costs associated with exit and disposal activities, including
      restructuring activities. SFAS No. 146 requires that costs associated with
      exit or disposal activities be recognized when they are incurred rather
      than at the date of a commitment to an exit or disposal plan. SFAS No. 146
      is effective for all exit or disposal activities initiated after December
      31, 2002. The provision of issue 94-3 shall continue to apply for an exit
      activity initiated under an exit plan that met the criteria of issue 94-3
      prior to this statements initial application. The Company does not expect
      the adoption of SFAS No. 146 to have a material impact on our results of
      operations or financial position.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         | In November 2002, the FASB issued FASB
      Interpretation No. 45, Guarantors Accounting and Disclosure Requirements
      for Guarantees, Including Indirect Guarantees of Indebtedness of Others,
      an interpretation of FASB Statements No. 5, 57, and 107 and Rescission of
      FASB Interpretation No. 34 (FIN No. 45). FIN No. 45 elaborates on the
      disclosures to be made by a guarantor in its interim and annual financial
      statements about its obligations under certain guarantees that it has
      issued. It also clarifies that a guarantor is required to recognize, at
      the inception of a guarantee, a liability for the fair value of the
      obligation undertaken in issuing the guarantee. FIN No. 45 does not
      prescribe a specific approach for subsequently measuring the guarantors
      recognized liability over the term of the related guarantee. It also
      incorporates, without change, the guidance in FASB Interpretation No. 34,
      Disclosure of Indirect Guarantees of Indebtedness of Others, which is
      being superseded. The disclosure provisions of FIN No. 45 are effective
      for financial statements of interim or annual periods that end after
      December 15, 2002 and the provisions for initial recognition and
      measurement are effective on a prospective basis for guarantees that are
      issued or modified after December 31, 2002, irrespective of a guarantors
      year-end. The Company does not expect the adoption of FIN No. 45 to have a
      material impact on its results of operations or financial
      position.

- 20 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES
      (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | In November 2002, the Emerging Issues Task
      Force (EITF) of the FASB reached a consensus on EITF No. 00-21,
      Accounting for Revenue Arrangements with Multiple Element Deliverables.
      The issue addresses how to account for arrangements that may involve
      multiple revenue-generating activities, i.e., the delivery or performance
      of multiple products, services, and/or rights to use assets. In applying
      this guidance, separate contracts with the same party, entered into at or
      near the same time, will be presumed to be a package, and the
      consideration will be measured and allocated to the separate units based
      on their relative fair values. This consensus guidance will be applicable
      to agreements entered into in quarters beginning after June 15, 2003.The
      Company will adopt this new accounting effective July 1, 2003. The Company
      is currently evaluating the impact of this change.                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | In January 2003, the FASB issued
      Interpretation No. 46, Consolidation of Variable Interest Entities(FIN 46). The objective of FIN 46 is to improve financial
      reporting by companies involved with variable interest entities. A
      variable interest entity is a corporation, partnership, trust, or any
      other legal structure used for business purposes that either (a) does not
      have equity investors with voting rights or (b) has equity investors that
      do not provide sufficient financial resources for the entity to support
      its activities. FIN 46 requires a variable interest entity to be
      consolidated by a company if that company is subject to a majority of the
      risk of loss from the variable interest entitys activities or entitled to
      receive a majority of the entitys residual returns or both. FIN 46 also
      requires disclosures about variable interest entities that the company is
      not required to consolidate but in which it has a significant variable
      interest. The consolidation requirements of Interpretation 46 apply
      immediately to variable interest entities created after January 31, 2003.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | The consolidation requirements apply to
      holder entities in the first fiscal year or interim period beginning after
      June 15, 2003. Certain of the disclosure requirements apply in all
      financial statements issued after January 31, 2003, regardless of when the
      variable interest entity was established. As of December 31, 2002, does
      not expect that the adoption of FIN 46 will have a material effect on its
      financial position or results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

- 21 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

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

| |                     |  | December
      31, |    
| | ------------------- |  | ------------------ | ---
| |                     |  |                    |    
| |                     |  | 2001               |    
| |                     |  |                    |    
| |                     |  | Amortizedcost      |    
| |                     |  |                    |    
| | Available-for-sale: |  |                    |    
| | Equity securities   |  | $                  | 718
| |                     |  |                    |    

|         | During 2001 and 2002, the Companys
      management evaluated whether the securities decline in value is other
      than temporary and other than temporary declines were recognized as loss
      in the amount of $ 1,004 and $ 391, respectively, in its statement of
      operations. The cost basis of these securities was written down to fair
      value as a new cost basis,                   
|-------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                              
|         | During 2001, the Company recorded proceeds
      from sale of available - for - sale securities in the amount of $ 11,004.
      The gross realized gains on sale of available - for - sale marketable
      securities totaled $ 65.                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                              
|         | The net adjustment to unrealized holding
      losses on available-for-sale marketable securities included as a separate
      component of shareholders equity totaled, $ 3,420, $ 298 and $ 395 in 2000,
      2001 and 2002, respectively. The net adjustment to unrealized holding
      losses for 2000, 2001 and 2002, net of taxes, is in the amount of $ 1,923,
      $ 185 and $ 326, respectively.
|         |                                                                                                                                                                                                                                                                                                                                                                                                              
|NOTE 4:- | OTHER ACCOUNTS RECEIVABLE AND PREPAID
      EXPENSES                                                                                                                                                                                                                                                                                                                                                         

| |                                                                                    |  | December
      31, |      
| | ---------------------------------------------------------------------------------- |  | ------------------ | -----
| |                                                                                    |  |                    |      
| |                                                                                    |  | 2001               |      
| |                                                                                    |  |                    |      
| | Loans to employees (1)                                                             |  | $                  | 889  
| | Interest receivable on marketable securities
      and long-term note   receivable |  |                    | 655  
| | Prepaid expenses                                                                   |  |                    | 811  
| | Government authorities                                                             |  |                    | 599  
| | Income receivable                                                                  |  |                    | 175  
| | Other                                                                              |  |                    | 474  
| |                                                                                    |  |                    |      
| |                                                                                    |  | $                  | 3,603
| |                                                                                    |  |                    |      

| | (1) | In March 2000, the Company had
      entered into loan agreements with several of its officers pursuant to
      which the Company granted these officers loans that as of December 31,
      2001 totaled $ 1,132, which include $ 91 accumulated interest, for the
      purpose of enabling them to invest in the Tamir Fishman Ventures II Ltd.
      venture capital fund a public company which its shares are traded on the Tel-Aviv Stock Exchange.
 The loans are linked to the Israeli Consumer Price Index (CPI) and bear interest at the rate of 4% per year.
      The loan agreements were cancelled in January 2002. The employees and
      former employees transferred their shares in Tamir Fishman Venture II Ltd.
      to the Company in exchange for the waiver of their commitment. An
      allowance of  $ 500 was provided in 2001 for the loss and was recorded
      as compensation expenses in the statements of
  operations.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

- 22 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 4:- | OTHER ACCOUNTS RECEIVABLE AND PREPAID
      EXPENSES (Cont.)
|-------- | ------------------------------------------------------------
|         |                                                             
|         |                                                             
|         |                                                             
|NOTE 5:- | INVENTORIES                                                 

| |                                         |  | December
      31, |      
| | --------------------------------------- |  | ------------------ | -----
| |                                         |  |                    |      
| |                                         |  | 2001               |      
| |                                         |  |                    |      
| | Raw materials, parts and
      supplies |  | $                  | 4,653
| | Work-in-progress                        |  |                    | 545  
| | Finished products                       |  |                    | 2,205
| |                                         |  |                    |      
| |                                         |  |                    |      
| |                                         |  | $                  | 7,403
| |                                         |  |                    |      

|NOTE 6:- | INVESTMENT IN
    AFFILIATE
|-------- | ---------------------------

| |                                                                           |  | December
      31, |       
| | ------------------------------------------------------------------------- |  | ------------------ | ------
| |                                                                           |  |                    |       
| |                                                                           |  | 2001               |       
| |                                                                           |  |                    |       
| | Investment as of purchase
    date                                        |  | $                  | 542   
| | Convertible bond (1)                                                      |  |                    | 1,053 
| | Long-term loan (1) (2)                                                    |  |                    | 100   
| | Accumulated losses                                                        |  |                    | (1,725
| | Foreign currency translation
      adjustments                            |  |                    | 144   
| |                                                                           |  |                    |       
| |                                                                           |  |                    |       
| |                                                                           |  |                    | 114   
| | Impairment of investment in an affiliate
      (3)                        |  |                    | -     
| |                                                                           |  |                    |       
| |                                                                           |  |                    |       
| | Total investment in an affiliate accounted
      for by the equity method |  | $                  | 114   
| |                                                                           |  |                    |       

| | (1) | As of December 31, 2001, $1,053 out
      of the long-term loan was exchanged to convertible bond as a result of an
      agreement signed between the Company and the affiliate on March 28,
      2001.                                                                         
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |     |                                                                                                                                                                                                                                                                                   
| |     | According to the agreement, the
      convertible bond shall be redeemable by March 28, 2006, or at such time as
      the affiliate completes an equity financing in the amount of $ 2,000,
      whichever is earlier. The conversion will be to Class A Preferred
      shares.
| |     |                                                                                                                                                                                                                                                                                   
| | (2) | Long-term loan - the balance is
      linked to the U.S. dollar and bears no interest. As of December 31, 2002,
      the loan has no maturity date. In 2002, the Company loaned to the affiliate an additional amount of $987.                                                   

- 23 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 6:- | INVESTMENT IN AFFILIATE
      (Cont.)                                                                                                                                                                                                                                                                   
|-------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                         
|         | (3)                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                         
|NOTE 7:- | INVESTMENT IN OTHER
      COMPANY                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                         
|         | During 2002 the Company made an additional
      investments of $ 444 in Tamir Fishman Ventures II, LLC. The Company does
      not have the ability to exercise significant influence and therefore the
      investment was stated at cost.                                                           
|         |                                                                                                                                                                                                                                                                                                         
|         | As a result of significant uncertainty over
      the future realization of the investment, as of December 31, 2002, based
      on managements most recent analyses, impairment losses have been
      identified in the amount of $ 1,038. The impairment charge is included in
      other expenses.
|         |                                                                                                                                                                                                                                                                                                         
|NOTE 8:- | PROPERTY AND EQUIPMENT,
      NET                                                                                                                                                                                                                                                                       

| |                                          |  | December
      31, |       
| | ---------------------------------------- |  | ------------------ | ------
| |                                          |  |                    |       
| |                                          |  | 2001               |       
| |                                          |  |                    |       
| | Cost:                                    |  |                    |       
| | Computers and peripheral
      equipment |  | $                  | 9,714 
| | Office furniture and
    equipment       |  |                    | 2,224 
| | Motor vehicles                           |  |                    | 999   
| | Leasehold improvements                   |  |                    | 1,143 
| |                                          |  |                    |       
| |                                          |  |                    |       
| |                                          |  |                    | 14,080
| | Accumulated depreciation                 |  |                    | 9,624 
| |                                          |  |                    |       
| |                                          |  |                    |       
| | Depreciated cost                         |  | $                  | 4,456 
| |                                          |  |                    |       



| | Depreciation expenses for the years ended
      December 31, 2000, 2001 and 2002, amounted to $ 2,352, $ 2,149
      and $ 2,102, respectively.
| | -----------------------------------------------------------------------------------------------------------------------------------------------

- 24 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 9:- | INTANGIBLE ASSETS,
  NET
|-------- | ------------------------
|         |                         
|         | a.                      

| |                          |  | December
      31, |      
| | ------------------------ |  | ------------------ | -----
| |                          |  |                    |      
| |                          |  | 2001               |      
| |                          |  |                    |      
| | Cost                     |  | $                  | 1,038
| | Accumulated amortization |  |                    | 94   
| |                          |  |                    |      
| |                          |  |                    |      
| |                          |  | $                  | 944  
| |                          |  |                    |      

| | b. | Amortization expenses for the years
      ended December 31, 2000, 2001 and 2002, amounted to $ 0, $ 94
      and $ 208, respectively.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                       
| | c. | Estimated amortization expenses for
      the years ended:                                                                            
| |    |                                                                                                                                       

| | 2003 |  | $ | 222 |  | 
| | ---- |  | - | --- |  | 
| | 2004 |  |   | 207 |  | 
| | 2005 |  |   | 207 |  | 
| | 2006 |  |   | 116 |  | 
| |      |  |   |     |  | 
| |      |  |   |     |  | 
| |      |  | $ | 752 |  | 
| |      |  |   |     |  | 

|NOTE 10:- | GOODWILL                                                                                                                                                                                                                                         
|--------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|          |                                                                                                                                                                                                                                                  
|          | The results of operations presented below
      for the three years ended December 31, 2002, 2001 and 2000, reflect the
      operations had the Company adopted the non-amortization provisions of SFAS
      No. 142 effective January 1, 2000:

| |                                              |                                    | Year ended December
      31, |      
| | -------------------------------------------- | ---------------------------------- | ----------------------------- | -----
| |                                              |                                    |                               |      
| |                                              |                                    | 2000                          |      
| |                                              |                                    |                               |      
| | Reported net income (loss)                   |                                    | $                             | 1,440
| | Goodwill amortization                        |                                    |                               | 2,680
| |                                              |                                    |                               |      
| | Adjusted net income (loss)                   |                                    | $                             | 4,120
| |                                              |                                    |                               |      
| |                                              |                                    |                               |      
| | Basic net earnings (loss) per
      share:   |                                    |                               |      
| |                                              | Reported net earnings
      (loss) |                               | $    
| |                                              | Goodwill amortization              |                               |      
| |                                              |                                    |                               |      
| |                                              |                                    |                               |      
| |                                              | Adjusted net earnings
      (loss) |                               | $    
| |                                              |                                    |                               |      
| | Diluted net earnings (loss) per
      share: |                                    |                               |      
| |                                              | Reported net income
      (loss)   |                               | $    
| |                                              | Goodwill amortization              |                               |      
| |                                              |                                    |                               |      
| |                                              |                                    |                               |      
| | Adjusted net earnings (loss)                 |                                    | $                             | 0.35 
| |                                              |                                    |                               |      

- 25 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 11:- | ACCRUED EXPENSES AND OTHER ACCOUNTS
      PAYABLE
|--------- | -------------------------------------------------

| |                                                |  | December
      31, |      
| | ---------------------------------------------- |  | ------------------ | -----
| |                                                |  |                    |      
| |                                                |  | 2001               |      
| |                                                |  |                    |      
| | Employees and payroll
    accruals             |  | $                  | 2,758
| | Accrued expenses                               |  |                    | 809  
| | Amount collected on behalf of a
      customer |  |                    | -    
| | Restructuring accrual (1)                      |  |                    | -    
| | Other                                          |  |                    | 15   
| |                                                |  |                    |      
| |                                                |  |                    |      
| |                                                |  | $                  | 3,582
| |                                                |  |                    |      

|          | (1)                                          | See also Note 1d.                                                                                                                        
|--------- | -------------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------
|          |                                              |                                                                                                                                          
|NOTE 12:- | COMMITMENTS AND CONTINGENT
      LIABILITIES
|          |                                              |                                                                                                                                          
|          | a.                                           | Lease commitments:                                                                                                                       
|          |                                              |                                                                                                                                          
|          |                                              | The premises and vehicles of the
      Company and its subsidiaries are leased under various operating leases
      which expire in 2007.
|          |                                              |                                                                                                                                          
|          |                                              | The future minimum lease
      commitments, under non-cancelable operating lease agreements, are as
      follows:                       

| |      |  | Year ended December
      31, |      
| | ---- |  | ----------------------------- | -----
| |      |  |                               |      
| |      |  | Facilities                    |      
| |      |  |                               |      
| | 2003 |  | $                             | 1,580
| | 2004 |  |                               | 1,344
| | 2005 |  |                               | 751  
| | 2006 |  |                               | 453  
| | 2007 |  |                               | 141  
| |      |  |                               |      
| |      |  |                               |      
| |      |  | $                             | 4,269
| |      |  |                               |      

| |    | Facilities lease expenses for the
      years 2000, 2001 and 2002, amounted to $  1,204, $ 1,842 and $
      1,618, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | Vehicle lease expenses for the
      years ended December 31, 2000, 2001 and 2002 were approximately $ 171, $
      581 and $ 895, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | b. | Litigation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | On October, 2002, a claim was
      brought by Hilgraeve, Inc. against the Company, its United States
      subsidiary and other companies, including one of its resellers in respect
      of whom the Company agreed to represent and indemnify. In this action,
      which is currently in the discovery stage, the plaintiff claims that the
      eSafe product infringes on the plaintiffs United States patent. The
      plaintiff has requested an injunction and damages. The Companys
      management and its legal counsel can not estimate any costs that can arise from the
      claim.

- 26 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 12:- | COMMITMENTS AND CONTINGENT LIABILITIES
      (Cont.)
|--------- | ----------------------------------------------------
|          |                                                     
|          | c.                                                  
|          |                                                     
|          |                                                     
|          |                                                     
|NOTE 13:- | TAXES ON INCOME                                     
|          |                                                     
|          | a.                                                  
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     
|          |                                                     

- 27 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 13:- | TAXES ON INCOME
    (Cont.)
|--------- | ---------------------------
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            

- 28 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 13:- | TAXES ON INCOME
    (Cont.)
|--------- | ---------------------------
|          |                            
|          | b.                         
|          |                            
|          |                            
|          |                            
|          | c.                         
|          |                            
|          |                            
|          |                            
|          |                            
|          |                            
|          | d.                         
|          |                            
|          |                            
|          |                            
|          | e.                         

| |          |  | Year
      endedDecember 31, |       
| | -------- |  | ---------------------------- | ------
| |          |  |                              |       
| |          |  | 2000                         |       
| |          |  |                              |       
| | Domestic |  | $                            | 8,213 
| | Foreign  |  |                              | (4,810
| |          |  |                              |       
| |          |  | $                            | 3,403 
| |          |  |                              |       

- 29 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 13:- | TAXES ON INCOME
    (Cont.)
|--------- | ---------------------------
|          |                            
|          | f.                         

| |                               |  | Year
      endedDecember 31, |      
| | ----------------------------- |  | ---------------------------- | -----
| |                               |  |                              |      
| |                               |  | 2000                         |      
| |                               |  |                              |      
| | Current taxes                 |  | $                            | 2,239
| | Tax in respect of prior
years |  |                              | (703 
| | Deferred taxes                |  |                              | 104  
| |                               |  |                              |      
| |                               |  | $                            | 1,640
| |                               |  |                              |      
| |                               |  |                              |      
| | Domestic                      |  | $                            | 2,083
| | Foreign                       |  |                              | (443 
| |                               |  |                              |      
| |                               |  | $                            | 1,640
| |                               |  |                              |      

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

| |                                                          |  | December
      31, |       
| | -------------------------------------------------------- |  | ------------------ | ------
| |                                                          |  |                    |       
| |                                                          |  | 2001               |       
| |                                                          |  |                    |       
| | Deferred tax assets:                                     |  |                    |       
| | Step up in FASTs assets
      (See also Note 15)        |  | $                  | 2,324 
| | Reserves and
      allowances                            |  |                    | 86    
| | Net operating loss
      carryforward in subsidiaries    |  |                    | 8,843 
| |                                                          |  |                    |       
| | Net deferred tax assets before valuation
      allowance |  |                    | 11,253
| | Valuation allowance                                      |  |                    | (7,764
| |                                                          |  |                    |       
| | Net deferred tax assets                                  |  | $                  | 3,489 
| |                                                          |  |                    |       
| | Domestic                                                 |  | $                  | 86    
| | Foreign                                                  |  |                    | 3,403 
| |                                                          |  |                    |       
| |                                                          |  | $                  | 3,489 
| |                                                          |  |                    |       

| |  | Aladdins subsidiaries in the U.K.,
      Netherlands and Germany have estimated total available carryforward tax
      losses of $ 2,421, $ 1,678 and $ 11,883, respectively to
      offset against future tax profits for an indefinite period. Aladdins
      subsidiary in the U.S. has estimated total available carryforward tax loss
      of $ 11,935 to offset against future taxable profits for 15-20 years.
      Utilization of U.S. net operating losses may be subject to a substantial
      annual limitation 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.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

- 30 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 13:- | TAXES ON INCOME
    (Cont.)
|--------- | ---------------------------
|          |                            
|          |                            
|          |                            
|          | h.                         

| |                                                                                            |                                                                                   | Year ended December
      31, |      
| | ------------------------------------------------------------------------------------------ | --------------------------------------------------------------------------------- | ----------------------------- | -----
| |                                                                                            |                                                                                   |                               |      
| |                                                                                            |                                                                                   | 2000                          |      
| |                                                                                            |                                                                                   |                               |      
| | Income (loss) before taxes, as reported in the
   consolidated statements of operations    |                                                                                   | $                             | 3,403
| |                                                                                            |                                                                                   |                               |      
| |                                                                                            |                                                                                   |                               |      
| | Statutory tax rate                                                                         |                                                                                   |                               | 36   
| |                                                                                            |                                                                                   |                               |      
| |                                                                                            |                                                                                   |                               |      
| | Theoretical tax expense (benefit) on the above
   amount at the Israeli statutory tax rate |                                                                                   | $                             | 1,225
| | Decrease in taxes resulting from Approved
   Enterprise benefits (1)                     |                                                                                   |                               | (713 
| | Tax adjustments in respect of inflation in Israel                                          |                                                                                   |                               | 111  
| | Tax adjustment in respect of different tax rate
   for foreign subsidiary                  |                                                                                   |                               | 116  
| | Operating carryforward losses for
      which   valuation allowance was provided           |                                                                                   |                               | 1,899
| | Items for which valuation allowance
      was   provided                                   |                                                                                   |                               | (325 
| | Non-deductible expenses                                                                    |                                                                                   |                               | 23   
| | Taxes in respect of prior
    years                                                        |                                                                                   |                               | (703 
| | Write-down of deferred tax
    asset                                                       |                                                                                   |                               | -    
| | Other                                                                                      |                                                                                   |                               | 7    
| |                                                                                            |                                                                                   |                               |      
| |                                                                                            |                                                                                   |                               |      
| | Actual tax expense                                                                         |                                                                                   | $                             | 1,640
| |                                                                                            |                                                                                   |                               |      
| | (1)                                                                                        | Per share amounts (basic) of the tax benefit
resulting from the exemption         |                               | $    
| |                                                                                            |                                                                                   |                               |      
| |                                                                                            |                                                                                   |                               |      
| |                                                                                            | Per share amounts (diluted) of the
      tax benefit resulting from the exemption |                               | $    
| |                                                                                            |                                                                                   |                               |      

- 31 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 14:- | SHAREHOLDERS
  EQUITY
|--------- | ----------------------
|          |                       
|          | a.                    
|          |                       
|          | b.                    
|          |                       
|          | c.                    
|          |                       
|          | d.                    
|          |                       
|          |                       
|          |                       
|          |                       
|          |                       
|          |                       
|          |                       

| |                                                                            |  | 2000                   |           | 2001                         |  | 2002                   |      |                             
| | -------------------------------------------------------------------------- |  | ---------------------- | --------- | ---------------------------- |  | ---------------------- | ---- | ----------------------------
| |                                                                            |  |                        |           |                              |  |                        |      |                             
| |                                                                            |  | Amountof
      options |           | Weightedaverageexerciseprice |  | Amountof
      options |      | Weightedaverageexerciseprice
| |                                                                            |  |                        |           |                              |  |                        |      |                             
| | Outstanding at the  beginning of the
      year                            |  |                        | 861,950   |                              |  | $                      | 7.57 |                             
| | Granted                                                                    |  |                        | 653,100   |                              |  |                        | 4.88 |                             
| | Exercised                                                                  |  |                        | (145,685  | )                            |  |                        | 7.62 |                             
| | Canceled                                                                   |  |                        | (145,249  | )                            |  |                        | 8.67 |                             
| |                                                                            |  |                        |           |                              |  |                        |      |                             
| | Outstanding at the end  of the
      year                                  |  |                        | 1,224,116 |                              |  | $                      | 5.98 |                             
| |                                                                            |  |                        |           |                              |  |                        |      |                             
| | Exercisable at the end of  the
      year                                  |  |                        | 145,816   |                              |  | $                      | 7.69 |                             
| |                                                                            |  |                        |           |                              |  |                        |      |                             
| |                                                                            |  |                        |           |                              |  |                        |      |                             
| | Weighted average                                                           |  |                        |           |                              |  | $                      | 2.95 |                             
| |                                                                            |  |                        |           |                              |  |                        |      |                             
| | Fair value of options  granted during
      the  year at their grant  date |  |                        |           |                              |  |                        |      |                             

- 32 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

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

| |  | Exerciseprice |      | Optionsoutstandingas ofDecember
      31,2002 |  | Weightedaverageremaining contractuallife
      (years) |           | Weightedaverageexerciseprice |  | Optionsexercisableas ofDecember
      31,2002 |      | Weightedaverageexercise priceof
      exercisableoptions | 
| |  | ------------- | ---- | --------------------------------------------- |  | ------------------------------------------------------ | --------- | ---------------------------- |  | --------------------------------------------- | ---- | -------------------------------------------------------- | 
| |  |               |      |                                               |  |                                                        |           |                              |  |                                               |      |                                                          | 
| |  | $             | 1.20 |                                               |  |                                                        | 393,850   |                              |  |                                               | 9.82 |                                                          | 
| |  | $             | 2.62 |                                               |  |                                                        | 463,700   |                              |  |                                               | 8.88 |                                                          | 
| |  | $             | 3.50 |                                               |  |                                                        | 114,700   |                              |  |                                               | 8.43 |                                                          | 
| |  | $             | 4.50 |                                               |  |                                                        | 444,200   |                              |  |                                               | 2.90 |                                                          | 
| |  | $             | 7.50 |                                               |  |                                                        | 248,700   |                              |  |                                               | 1.16 |                                                          | 
| |  | $             | 8.50 |                                               |  |                                                        | 18,250    |                              |  |                                               | 1.37 |                                                          | 
| |  |               |      |                                               |  |                                                        |           |                              |  |                                               |      |                                                          | 
| |  |               |      |                                               |  |                                                        |           |                              |  |                                               |      |                                                          | 
| |  |               |      |                                               |  |                                                        | 1,683,400 |                              |  |                                               |      |                                                          | 
| |  |               |      |                                               |  |                                                        |           |                              |  |                                               |      |                                                          | 

|          | e.                                                                                                                                                                                                                                                                                                                                                                                                                       | Dividends:                                                                                                                                                                                     
|--------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|          |                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                
|          |                                                                                                                                                                                                                                                                                                                                                                                                                          | In the event that cash dividends
      are declared in the future, such dividends will be paid in NIS. The
      Company does not intend to pay cash dividends in the foreseeable
      future.
|          |                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                
|NOTE 15:- | RELATED PARTY
      TRANSACTIONS                                                                                                                                                                                                                                                                                                                                                                                        
|          |                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                
|          | Long-term note receivable - related
      parties:                                                                                                                                                                                                                                                                                                                                                                      
|          |                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | FAST Multimedia AG (FAST) is a
      wholly-owned subsidiary of FAST Multimedia, Inc., an entity controlled by
      the previous principal shareholder of FAST and a director of the Company.
      Amounts receivable from FAST were unsecured, fully subordinated to all
      other liabilities of FAST, bore interest at FIBOR plus 3% (FIBOR + 1.5% at
      December 31, 1997) and became due on June 30, 2001.
|          |                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | In January 2001, the Company signed an
      agreement to convert the long-term note receivable in the amount of $
      3,350 from FAST into 1,741,644 Series C Preferred shares of FAST
      Multimedia Inc. These shares represent 11.93% of the outstanding share
      capital of FAST Multimedia Inc.                                                                                                            
|          |                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | In September 2001, FAST sold its business
      activities to Pinnacle System which is listed for trade on the stock
      exchange in the U.S. in exchange for cash and shares of Pinnacle
      System.                                                                                                                                                                                                               
|          |                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | In view of the value of the transaction, and
      in view of the estimation of the Companys management that it will not be
      possible to realize the investment, management decided to write-off the
      balance of its investment in FAST and to recognize a loss in respect to
      this investment.                                                                                                         
|          |                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | The loss in respect of this investment, in
      the amount of $ 3,350 was recorded in 2001 under the other
      expenses item in the statements of
  operations.                                                                                                                                                                                                                                                      

- 33 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 16- | GEOGRAPHIC
  INFORMATION
|-------- | ------------------------
|         |                         
|         | a.                      
|         |                         
|         |                         
|         |                         
|         |                         

| |                              |  | 2000          |        | 2001             |  | 2002          |       
| | ---------------------------- |  | ------------- | ------ | ---------------- |  | ------------- | ------
| |                              |  |               |        |                  |  |               |       
| |                              |  | Totalrevenues |        | Long-livedassets |  | Totalrevenues |       
| |                              |  |               |        |                  |  |               |       
| | Israel                       |  | $             | 3,138  |                  |  | $             | 8,774 
| | Germany                      |  |               | 9,457  |                  |  |               | 3,960 
| | United States                |  |               | 13,835 |                  |  |               | 6,036 
| | Europe  (excluding  Germany) |  |               | 11,140 |                  |  |               | 1,262 
| | Southeast Asia               |  |               | 5,840  |                  |  |               | 260   
| | Other                        |  |               | 935    |                  |  |               | -     
| |                              |  |               |        |                  |  |               |       
| |                              |  |               |        |                  |  |               |       
| |                              |  | $             | 44,345 |                  |  | $             | 20,292
| |                              |  |               |        |                  |  |               |       

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



| |                                                  |  | Year
      endedDecember 31, |       
| | ------------------------------------------------ |  | ---------------------------- | ------
| |                                                  |  |                              |       
| |                                                  |  | 2000                         |       
| |                                                  |  |                              |       
| | Tokens (including HASP, Hardlock and Microguard) |  | $                            | 37,984
| | eSafe                                            |  |                              | 6,093 
| | Other                                            |  |                              | 268   
| |                                                  |  |                              |       
| |                                                  |  |                              |       
| |                                                  |  | $                            | 44,345
| |                                                  |  |                              |       

- 34 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 17- | SELECTED STATEMENTS OF OPERATIONS
      DATA
|-------- | --------------------------------------------
|         |                                             
|         | a.                                          
|         |                                             

| |                                                                         |  | Year
      endedDecember 31, |      
| | ----------------------------------------------------------------------- |  | ---------------------------- | -----
| |                                                                         |  |                              |      
| |                                                                         |  | 2000                         |      
| |                                                                         |  |                              |      
| | Financial expenses:                                                     |  |                              |      
| | Interest                                                                |  | $                            | (221 
| | Impairment of available
      for sale
      marketable      securities |  |                              | -    
| | Foreign currency
      translation differences                          |  |                              | (119 
| | Other                                                                   |  |                              | (37  
| |                                                                         |  |                              |      
| |                                                                         |  |                              |      
| |                                                                         |  |                              | (377 
| |                                                                         |  |                              |      
| | Financial income:                                                       |  |                              |      
| | Income from interest on
      marketable securities                     |  |                              | 589  
| | Interest                                                                |  |                              | 1,209
| | Foreign currency
      translation differences                          |  |                              | -    
| | Dividend                                                                |  |                              | -    
| |                                                                         |  |                              |      
| |                                                                         |  |                              |      
| |                                                                         |  |                              | 1,798
| |                                                                         |  |                              |      
| |                                                                         |  |                              |      
| |                                                                         |  | $                            | 1,421
| |                                                                         |  |                              |      

| | b. | Other income (expenses), net:
| | -- | -----------------------------

| |                                                                  |  |   |       |  |  |   |        |   |  |   |        |   | 
| | ---------------------------------------------------------------- |  | - | ----- |  |  | - | ------ | - |  | - | ------ | - | 
| | Gain on sale of available for sale
      marketable   securities |  | $ | 5,468 |  |  | $ | -      |   |  | $ | -      |   | 
| | Impairment of investment in other company
      (FAST)           |  |   | -     |  |  |   | (3,350 | ) |  |   | -      |   | 
| | Impairment of investment in other
      company                  |  |   | -     |  |  |   | -      |   |  |   | (1,038 | ) | 
| | Capital gain (loss) on sale of property
      and   equipment    |  |   | 11    |  |  |   | (22    | ) |  |   | 35     |   | 
| | Other, net                                                       |  |   | 4     |  |  |   | -      |   |  |   | 71     |   | 
| |                                                                  |  |   |       |  |  |   |        |   |  |   |        |   | 
| |                                                                  |  |   |       |  |  |   |        |   |  |   |        |   | 
| |                                                                  |  | $ | 5,483 |  |  | $ | (3,372 | ) |  | $ | (932   | ) | 
| |                                                                  |  |   |       |  |  |   |        |   |  |   |        |   | 

- 35 -

---

---

|ALADDIN KNOWLEDGE SYSTEMS
      LTD.            
|------------------------------------------------
|AND ITS
  SUBSIDIARIES                          
|NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS
|                                                
|U.S. dollars in
    thousands                   

|NOTE 17- | SELECTED STATEMENTS OF OPERATIONS DATA
      (cont.)
|-------- | ----------------------------------------------------
|         |                                                     
|         | c.                                                  
|         |                                                     
|         |                                                     

| |                                                                                                                                  |  | Year ended December
      31, |       
| | -------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------------- | ------
| |                                                                                                                                  |  |                               |       
| |                                                                                                                                  |  | 2000                          |       
| |                                                                                                                                  |  |                               |       
| | Numerator:                                                                                                                       |  |                               |       
| | Net income (loss)                                                                                                                |  | $                             | 1,440 
| |                                                                                                                                  |  |                               |       
| | Numerator for basic and diluted net
      earnings   (loss) per share - income (loss) available
      to   Ordinary shareholders |  | $                             | 1,440 
| |                                                                                                                                  |  |                               |       
| |                                                                                                                                  |  |                               |       
| | Denominator:                                                                                                                     |  |                               |       
| | Weighted average number of
      shares                                                                                          |  |                               | 11,446
| | Treasury shares                                                                                                                  |  |                               | 22    
| |                                                                                                                                  |  |                               |       
| | Denominator for basic net earnings (loss)
      per   share-weighted-average number of
      shares                              |  |                               | 11,424
| |                                                                                                                                  |  |                               |       
| | Effect of dilutive
    securities:                                                                                               |  |                               |       
| | Employee stock options                                                                                                           |  |                               | 319   
| |                                                                                                                                  |  |                               |       
| |                                                                                                                                  |  |                               |       
| | Dilutive potential Ordinary
      shares                                                                                         |  |                               | 319   
| |                                                                                                                                  |  |                               |       
| | Denominator for diluted net earnings
      (loss)   per share                                                                    |  |                               | 11,743
| |                                                                                                                                  |  |                               |       

| |  | *)     Antidilutive.
| |  | --------------------

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

- 36 -

---

---

EXHIBIT 8.1

|NAME OF SUBSIDIARY                                    | JURISDICTION OF INCORPORATION
|----------------------------------------------------- | -----------------------------
|Aladdin Knowledge Systems Inc.                        | New York                     
|Aladdin Japan & Co. Inc.                              | Japan                        
|Aladdin Western Europe Ltd.                           | England and Wales            
|Aladdin Western Europe BV                             | Holland                      
|Hafalad BV                                            | Holland                      
|Aladdin Western Europe Ltd.
(Aladdin France S.A.R.L.) | France                       
|Aladdin Knowledge Systems
Deutschland GmbH            | Germany                      
|Aladdin Knowledge Systems GmbH & Co. KG               | Germany                      
|Aladdin Knowledge Verwaltung GmbH                     | Germany                      



---

---

EXHIBIT 12.1

CONSENT OF INDEPENDENT AUDITORS

We consent to the incorporation by reference
in the Registration Statement on Form F-3 and the Registration Statement on Form S-8
pertaining to the Aladdin Knowledge
Systems Ltd. Share Option Plans,
of our report dated February 5, 2003 with respect to the Consolidated Financial
Statements of Aladdin Knowledge Systems Ltd., included in this Annual Report
(Form 20-F) for the year ended December 31, 2002.

|Tel - Aviv,
  Israel |  | KOST FORER & GABBAY             
|-------------------- |  | --------------------------------
|June 27,
  2003      |  | A Member of Ernst & Young Global

---

---

CONSENT OF INDEPENDENT AUDITORS

We consent to the incorporation by reference
in the Registration Statement on Form F-3 and the Registration Statement on Form S-8
pertaining to the Aladdin Knowledge
Systems Ltd. (the Company) Share Option Plans, of our report dated February 4, 2003 with respect to the Financial
Statements of Aladdin Western Europe Ltd., included in the Companys Annual
Report (Form 20-F) for the year ended December 31, 2002.

| |  | BLICK
  ROTHENBERG   
| |  | ---------------------
| |  | Chartered Accountants
| |  | Registered
  Auditors

12 York Gate
Regents Park
London NW1 4QS

June 26, 2003

---

---

EXHIBIT 12.2

CERTIFICATION PURSUANT TO
18 U.S.C SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In
connection with the Annual Report of Aladdin Knowledge Systems Ltd. (the
Company) on Form 20-F for the year ended December 31, 2002 as filed with the
Securities and Exchange Commission on the date hereof (the Report), I, Yanki
Margalit, Chief Executive Officer of the Company, certify, pursuant to 18
U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley
Act of 2002, that to my knowledge:

| | 1. | the Report
  fully complies with the requirements of section 13(a) of the Securities
  Exchange Act of 1934; and                                        
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                         
| | 2. | the
  information contained in the Report fairly presents, in all material respects,
  the financial condition and results of operations of the Company.

| | /s/ YANKI
  MARGALIT     
| | -------------------------
| |                          
| | Yanki
  Margalit         
| | Chief
  Executive Officer

A signed original of this written statement required by Section 906 has
been provided to the Company and will be retained by the Company and furnished
to the Securities and Exchange Commission or its staff upon request.

---

---

EXHIBIT 12.3

CERTIFICATION PURSUANT TO
18 U.S.C SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In
connection with the Annual Report of Aladdin Knowledge Systems Ltd. (the
Company) on Form 20-F for the year ended December 31, 2002 as filed with the
Securities and Exchange Commission on the date hereof (the Report), I, Erez
Rosen, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C.
section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of
2002, that to my knowledge:

| | 1. | the Report
  fully complies with the requirements of section 13(a) of the Securities
  Exchange Act of 1934; and                                        
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                         
| | 2. | the
  information contained in the Report fairly presents, in all material
  respects, the financial condition and results of operations of the Company.

| | /s/ EREZ
  ROSEN         
| | -------------------------
| |                          
| | Erez Rosen               
| | Chief
  Financial Officer

A signed original of this
written statement required by Section 906 has been provided to the Company and
will be retained by the Company and furnished to the Securities and Exchange
Commission or its staff upon request.

---

---