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

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FORM
20-F


|                                                                                                             |                                                                                                   
|------------------------------------------------------------------------------------------------------------ | --------------------------------------------------------------------------------------------------
|o                                                                                                            | REGISTRATION
  STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF
  1934
|                                                                                                             |                                                                                                   
|                                                                                                             | OR                                                                                                
|                                                                                                             |                                                                                                   
|x                                                                                                            | ANNUAL
  REPORT PURSUANT TO SECTION 13 OF 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934            
|                                                                                                             |                                                                                                   
|                                                                                                             | For
  the fiscal year ended December 31, 2006                                                     
|                                                                                                             |                                                                                                   
|                                                                                                             | OR                                                                                                
|                                                                                                             |                                                                                                   
|o                                                                                                            | TRANSITION
  REPORT PURSUANT TO SECTION 13 OR 15(d)
  OF THE SECURITIES EXCHANGE ACT OF 1934      
|                                                                                                             |                                                                                                   
|                                                                                                             | For
  the transition period from __________ to __________                                         
|                                                                                                             |                                                                                                   
|o                                                                                                            | SHELL
  COMPANY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
  OF 1934   
|                                                                                                             | Date
  of event requiring this shell company report _____________                                 
|                                                                                                             |                                                                                                   
|                                                                                                             | Commission File No.
  1-8201                                                                      
|                                                                                                             |                                                                                                   
|ALADDIN KNOWLEDGE SYSTEMS LTD.                                                                              
|(Exact name of
  Registrant as specified in its charter and translation of Registrants name
  into English)

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Israel(Jurisdiction of incorporation or organization)35 Efal Street, Kiryat Arye, Petach Tikva 49511, Israel
(Address of principal executive offices)


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Securities
registered or to be registered pursuant to Section 12(b) of the Act:Ordinary Shares, nominal value 0.01 New Israeli Shekel per
share
(Class of Securities)


Nasdaq Global
Market
(Name of Exchange)

Securities
registered or to be registered pursuant to Section 12(g) of the Act:None
(Title of Class)

Securities
for which there is a reporting obligation pursuant to Section 15(d) of the Act:None
(Title of Class)

Indicate the
number of outstanding shares of each of the issuers classes of capital or
common stock as ofDecember 31, 2006:

14,683,488
Ordinary Shares

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

o
Yes
x No

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

x
Yes
o No

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

o
Yes
x No

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

o Large
Accelerated Filerx Accelerated
Filer o Non-Accelerated Filer

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

Item 17 oItem
18 x

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

o
Yes
 x No

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CAUTIONARY
NOTE FOR FORWARD-LOOKING STATEMENTS

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

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

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

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

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

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

---



TABLE OF CONTENTS

|            |  |                                                                                |  |   
|----------- |  | ------------------------------------------------------------------------------ |  | --
|PART I.     |  |                                                                                |  | 1 
|Item
  1.   |  | IDENTITY OF DIRECTORS, SENIOR
  MANAGEMENT AND ADVISERS                        |  | 1 
|Item
  2.   |  | OFFER STATISTICS AND EXPECTED
  TIMETABLE                                      |  | 1 
|Item
  3.   |  | KEY INFORMATION                                                                |  | 1 
|Item
  4.   |  | INFORMATION ON THE COMPANY                                                     |  | 12
|Item
  5.   |  | OPERATING AND FINANCIAL REVIEW AND
  PROSPECTS                                 |  | 24
|Item
  6.   |  | DIRECTORS, SENIOR MANAGEMENT AND
  EMPLOYEES                                   |  | 36
|Item
  7.   |  | MAJOR SHAREHOLDERS AND RELATED PARTY
  TRANSACTIONS                            |  | 41
|Item
  8.   |  | FINANCIAL INFORMATION                                                          |  | 43
|Item
  9.   |  | THE OFFER AND LISTING                                                          |  | 44
|Item
  10.  |  | ADDITIONAL INFORMATION                                                         |  | 46
|Item
  11.  |  | QUANTITATIVE AND QUALITATIVE
  DISCLOSURES ABOUT MARKET RISK                   |  | 56
|Item
  12.  |  | DESCRIPTIONS OF SECURITIES OTHER THAN
  EQUITY SECURITIES                      |  | 57
|            |  |                                                                                |  |   
|PART II.    |  |                                                                                |  | 57
|Item
  13.  |  | DEFAULTS, DIVIDEND ARREARAGES AND
  DELINQUENCIES                              |  | 57
|Item  14.   |  | MATERIAL MODIFICATIONS TO THE RIGHTS
  OF SECURITY HOLDERS AND USE OF PROCEEDS |  | 57
|Item
  15T. |  | CONTROLS AND PROCEDURES                                                        |  | 57
|Item
  16A. |  | AUDIT COMMITTEE FINANCIAL EXPERT                                               |  | 58
|Item
  16B. |  | CODE OF ETHICS                                                                 |  | 58
|Item
  16C. |  | PRINCIPAL ACCOUNTANT FEES AND
  SERVICES                                       |  | 58
|Item
  16D. |  | EXEMPTIONS FOR THE LISTING STANDARDS
  FOR AUDIT COMMITTEES                    |  | 59
|Item
  16E. |  | PURCHASE OF EQUITY SECURITIES BY THE
  ISSUER AND AFFILIATED PURCHASERS        |  | 59
|            |  |                                                                                |  |   
|PART III.   |  |                                                                                |  | 59
|Item
  17.  |  | FINANCIAL STATEMENTS                                                           |  | 59
|Item
  18.  |  | FINANCIAL STATEMENTS                                                           |  | 59
|Item
  19.  |  | EXHIBITS                                                                       |  | 59

---



PART I.

|                  |                                                        
|----------------- | -------------------------------------------------------
|Item 1.           | IDENTITY OF DIRECTORS, SENIOR
  MANAGEMENT AND ADVISERS
|                  |                                                        
|Not
  Applicable.
|                  |                                                        
|Item 2.           | OFFER STATISTICS AND EXPECTED
  TIMETABLE              
|                  |                                                        
|Not
  Applicable.
|                  |                                                        
|Item 3.           | KEY INFORMATION                                        

A.                    Selected Financial Data

We
derived the selected consolidated statement of operations data set forth below
for the years ended December 31, 2004, 2005 and 2006, and the selected
consolidated balance sheet data as of December 31, 2005 and 2006, from our
audited consolidated financial statements, included elsewhere in this annual
report. We derived the consolidated statement of operations data for the years
ended December 31, 2002 and 2003 and the selected consolidated balance sheet
data as of December 31, 2002, 2003 and 2004 from audited consolidated financial
statements that are not included in this annual report. See Note 2 to our
consolidated financial statements for a discussion of our significant
accounting policies. Our consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States,
referred to as GAAP.

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

---



|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|---------------------------------------------------------------------------------- |  | ---------------------------------------------- | ------ | ---- | - | ------ | - | ---- | ------ | ---- | - | ------ |  | - | ------ | 
|                                                                                   |  | Year ended December 31,                        |       
|                                                                                   |  | 2002                                           |        | 2003 |   | 2004   |   | 2005 |        | 2006 |  
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |  
|                                                                                   |  | (In thousands, except earnings per share data) |       
|Consolidated statement of
  operations data:                                       |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Revenues:                                                                          |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Software
  security                                                                |  | $                                              | 40,093 |      | $ | 43,521 |   | $    | 50,650 |      | $ | 56,578 |  | $ | 60,556 | 
|Enterprise
  security                                                              |  |                                                | 9,427  |      |   | 11,204 |   |      | 18,471 |      |   | 25,195 |  |   | 28,482 | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Total revenues                                                                     |  |                                                | 49,520 |      |   | 54,725 |   |      | 69,121 |      |   | 81,773 |  |   | 89,038 | 
|Cost of revenues:                                                                  |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Software
  security                                                                |  |                                                | 8,405  |      |   | 7,995  |   |      | 9,541  |      |   | 9,870  |  |   | 9,292  | 
|Enterprise
  security                                                              |  |                                                | 1,833  |      |   | 1,804  |   |      | 4,240  |      |   | 7,101  |  |   | 10,721 | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Total cost of revenues                                                             |  |                                                | 10,238 |      |   | 9,799  |   |      | 13,781 |      |   | 16,971 |  |   | 20,013 | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Gross profit                                                                       |  |                                                | 39,282 |      |   | 44,926 |   |      | 55,340 |      |   | 64,802 |  |   | 69,025 | 
|Operating expenses:                                                                |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Research and
  development                                                         |  |                                                | 12,245 |      |   | 12,759 |   |      | 12,028 |      |   | 12,131 |  |   | 14,336 | 
|Selling and
  marketing                                                            |  |                                                | 21,990 |      |   | 22,012 |   |      | 24,677 |      |   | 26,952 |  |   | 28,703 | 
|General and
  administrative                                                       |  |                                                | 7,247  |      |   | 7,745  |   |      | 8,805  |      |   | 11,169 |  |   | 12,780 | 
|Settlement
  charge                                                                |  |                                                |       |      |   |       |   |      |       |      |   | 2,000  |  |   |       | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Total operating expenses                                                           |  |                                                | 41,482 |      |   | 42,516 |   |      | 45,510 |      |   | 52,252 |  |   | 55,819 | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Operating income (loss)                                                            |  |                                                | (2,200 | )    |   | 2,410  |   |      | 9,830  |      |   | 12,550 |  |   | 13,206 | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Financial income, net                                                              |  |                                                | 491    |      |   | 480    |   |      | 53     |      |   | 1,038  |  |   | 3,240  | 
|Other income (expenses), net                                                       |  |                                                | (932   | )    |   | (5     | ) |      | (138   | )    |   | 14     |  |   | 284    | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Income (loss) before taxes on income                                               |  |                                                | (2,641 | )    |   | 2,885  |   |      | 9,745  |      |   | 13,602 |  |   | 16,730 | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Taxes on income                                                                    |  |                                                | 2,738  |      |   | 49     |   |      | 957    |      |   | 1,246  |  |   | 2,699  | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Income (loss)
  before equity in losses of an affiliate                            |  |                                                | (5,379 | )    |   | 2,836  |   |      | 8,788  |      |   | 12,356 |  |   | 14,031 | 
|Equity in losses of an affiliate                                                   |  |                                                | (1,257 | )    |   | (100   | ) |      |       |      |   |       |  |   |       | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Net income (loss)                                                                  |  | $                                              | (6,636 | )    | $ | 2,736  |   | $    | 8,788  |      | $ | 12,356 |  | $ | 14,031 | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Earnings (loss) per share:                                                         |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Basic                                                                              |  | $                                              | (0.59  | )    | $ | 0.24   |   | $    | 0.74   |      | $ | 0.89   |  | $ | 0.96   | 
|Diluted                                                                            |  |                                                | (0.59  | )    | $ | 0.23   |   | $    | 0.68   |      | $ | 0.85   |  | $ | 0.93   | 
|                                                                                   |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Weighted
    average number of shares used in computing earnings (loss) per share: |  |                                                |        |      |   |        |   |      |        |      |   |        |  |   |        | 
|Basic                                                                              |  |                                                | 11,253 |      |   | 11,287 |   |      | 11,940 |      |   | 13,899 |  |   | 14,596 | 
|Diluted                                                                            |  |                                                | 11,253 |      |   | 11,950 |   |      | 13,000 |      |   | 14,580 |  |   | 15,078 | 

2

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|                                                   |  |                  |        |      |   |        |  |      |        |      |   |         |  |   |         | 
|-------------------------------------------------- |  | ---------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------- |  | - | ------- | 
|                                                   |  | December
  31,   |       
|                                                   |  | 2002             |        | 2003 |   | 2004   |  | 2005 |        | 2006 |  
|                                                   |  |                  |        |      |   |        |  |      |        |      |  
|                                                   |  | (In
  thousands) |       
|Consolidated balance sheet data:                   |  |                  |        |      |   |        |  |      |        |      |   |         |  |   |         | 
|Cash, cash
  equivalents and marketable securities |  | $                | 15,095 |      | $ | 19,516 |  | $    | 25,911 |      | $ | 77,241  |  | $ | 90,881  | 
|Working capital                                    |  |                  | 22,664 |      |   | 26,625 |  |      | 34,111 |      |   | 84,974  |  |   | 99,801  | 
|Total assets                                       |  |                  | 48,539 |      |   | 55,468 |  |      | 70,894 |      |   | 125,878 |  |   | 148,044 | 
|Total
  liabilities                                |  |                  | 12,212 |      |   | 14,512 |  |      | 17,457 |      |   | 21,141  |  |   | 25,395  | 
|Share capital
  and additional paid-in capital     |  |                  | 36,184 |      |   | 36,184 |  |      | 39,735 |      |   | 78,998  |  |   | 82,483  | 
|Shareholders
  equity                             |  |                  | 36,327 |      |   | 40,956 |  |      | 53,437 |      |   | 104,737 |  |   | 122,649 | 

B.                    Capitalization and Indebtedness

Not
applicable.

C.                    Reasons for the Offer and Use of Proceeds

Not
applicable.

D.                    Risk Factors

Risks Related to Our Business

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

We
face intense competition in each of the segments in which we operate. In the
hardware-based software licensing authentication token, or SLAT, market, our
software digital rights management, or DRM, solutions compete with products
sold by SafeNet Inc. Our competitors in the authentication market are RSA
Security Inc., which holds a dominant position in the one-time passwords, or
OTP market, and SafeNet, which manufactures a USB-based authentication product.
We also compete with smart card manufacturers. Our primary competitor in the
content security market for gateway solutions is Trend Micro Inc., which holds
a dominant market position. In addition, the overall content security market is
characterized by a number of large companies, such as Symantec Corporation,
McAfee, Inc. and Trend Micro, which in 2006 together accounted for over 60% of
global revenues in this market as well as a large number of smaller companies.
While a substantial part of the products marketed by these companies provide
primarily desktop or network solutions and not the gateway solution offered by
eSafe, we face competition from some gateway solutions provided by these
companies. In addition, some vendors of firewalls offering gateway security
products, compete with our eSafe product. Many of our current and potential
competitors have significantly greater name recognition, larger customer bases
and greater financial, technical, manufacturing, marketing and other resources
than we do.  Our results of operations
will be adversely affected if our competitors succeed in marketing products
with superior performance or at lower prices than our products.

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

We
currently derive a substantial portion of our revenues and all of our profits
from our software DRM segment, consisting entirely of sales of our HASP line of
products. We expect to continue to derive a substantial portion of our revenues
and profits from this segment for the foreseeable future. Since our software
DRM products target the software industry, sales reflect trends in the software
business cycle. Demand for our software DRM products is driven, to some extent,
by end-user demand for software applications. If software vendors experience
deteriorating sales due to an economic downturn, demand for our software DRM
products could decline. This would have a material adverse effect on our
results of operations.

3

---



Sales of
our products at low gross margins may adversely affect our results of
operations.

In
order to penetrate emerging markets, from time to time we conclude transactions
at low gross margins. In 2006, gross margin from enterprise security decreased
to 62.4%, compared to 71.8% in 2005. The decrease in gross margin from
enterprise security was mainly attributable to several transactions made in the
Asia-Pacific region that were conducted at low gross margins in order to
increase our market share in the region. If we continue to enter into
transactions at low gross margins, our results of operations could be adversely
affected.

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

We
purchase certain key components for each of our hardware-based products from
sole source suppliers. In particular, we obtain from sole source suppliers the
application specific integrated circuits and microcontrollers included in our
HASP products, and the microcontroller and the smart card, including its
operating system, for our eToken products. In addition, we license the
anti-spam and web filtering functions incorporated in eSafe and receive
services related to these functions from a third party pursuant to a license
agreement that expires on December 31, 2007 but automatically renews for
unlimited successive one-year periods subject to either partys request to
terminate at the end of each year.  We
would need to seek an alternative licensor and service provider for these
functions if this third party ceases to provide these services or decides not
to extend the license. If any of our suppliers become unable to or refuses to
manufacture these components or if we experience delays in delivery of, or
shortages in, these components, which has happened from time to time, it could
interrupt and delay the manufacture of our products. In the event of a
disruption in supply, we cannot assure you that our inventory would be
sufficient to enable us to continue manufacturing during the time that it would
take to modify the design and integrate substitute components. Any such disruption
could adversely affect our results of operations.

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

We
cannot assure you that software publishers will continue to prefer to protect
their software through hardware-based solutions over software-based solutions.
A change in preference towards software-based solutions could materially
adversely affect the sales of our HASP HL token-based products, which currently
represent approximately 68% of
our total revenues.

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

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

Software
developers have started to add security features to new versions of their
software that are designed to limit intrusions by unauthorized users or viruses
and spyware via the Internet. Microsoft has announced an anti-virus service
geared towards consumers as well as a new strategy for anti-virus protection
for businesses. In addition the new version of Windows (Vista) has many
security features that are designed to minimize penetration of malicious code.
Stronger security in future Microsoft platforms may significantly minimize the
vulnerabilities

4

---



through which virus and vandal penetration is
possible. This, in turn, might lower the need to implement anti-virus and
content security solutions such as eSafe. As the incorporation of such features
in future versions of operating systems and software make these systems less
susceptible to outside penetration, our eSafe product may be rendered obsolete
or unmarketable.

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

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

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

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

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

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

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

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

Our
success and ability to compete greatly depends on our proprietary technology.
We rely on a combination of patents, copyrights, trademarks, trade secrets,
know-how and confidentiality clauses in our

5

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agreements to protect our intellectual property. We
cannot assure you that we will successfully protect our technology because:

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

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

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

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

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

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

We
market and sell our software DRM products through independent distributors in
all of the countries in which we do not have subsidiaries, and we market and
sell our eSafe and eToken product lines generally through indirect sales
channels, which include independent distributors. In 2006, 40% of our revenues
were generated from

6

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

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

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

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

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

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

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

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

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

7

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

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

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

Our
software DRM products do not provide absolute protection against piracy. We,
together with our customers, continuously face challenges from computer
hackers, who attempt to neutralize the protection our products provide in order
to enable unlicensed copying of our customers software. In recent years, we
have faced increasing attacks by hackers who have developed methods to
circumvent the protection provided by our software DRM products. Such methods
are often publicized over the Internet, making them readily available to those
who wish to make unlicensed copies of our customers software. We cannot
guarantee that hackers will not continue to develop methods to contravene the
protection provided by our products. Failure to provide effective software
protection solutions could seriously harm our business.

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

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

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

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

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

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

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

Our
activities in Europe require that we comply with European Union Directives with
respect to product quality assurance standards and environmental standards.
Directive 2002/95/ec of the European Parliament on the Restriction of the Use
of Certain Hazardous Substances in Electrical and Electronic Equipment, known
as the RoHS Directive, became effective on July 1, 2006 and requires that
certain of our products be modified to meet this regulation.  If we fail to achieve compliance, we may be
restricted from selling our products in the European Union and this could
adversely affect our results of operations.
European Directive 2002/96/EC on waste, electrical and electronic
equipment, known as the WEEE Directive, makes manufacturers of electrical and
electronic equipment

8

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

Risks Related to Our Ordinary Shares

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

Our
ordinary shares have been subject to and will continue to be subject to a great
deal of volatility. For example, during 2006, the price of our ordinary shares
on The Nasdaq Global Market fluctuated between $13.72 and $23.57 per share. We
cannot predict the fluctuations in the market price of our ordinary shares. The
broader market for technology stocks and, in particular, those of companies
based in Israel has also been subject to significant price fluctuations. These
broad market fluctuations may adversely affect the market price of our ordinary
shares, regardless of our actual operating performance. Such volatility in
relation to our ordinary shares may also affect our ability to raise additional
equity financing in the future.

Our
chairman and chief executive officer, Jacob (Yanki) Margalit, and our director,
Dany Margalit, have significant influence over matters requiring shareholder
and board approval.

Our
chairman and chief executive officer, Jacob (Yanki) Margalit, and our director,
Dany Margalit, collectively own or control 18.34% of our outstanding ordinary
shares. Messrs. Margalit are brothers, and both sit on our board of directors
which comprises a total of five members. Accordingly, they have significant
influence over the outcome of corporate actions requiring director or
shareholder approval, including the election of directors, any merger,
consolidation or sale of all or substantially all of our assets and any other
significant corporate transaction. These shareholders may also delay or prevent
a change of control of us, even if such a change of control would benefit our
other shareholders.

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

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

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

We
deliver our products promptly following the receipt of customer orders and,
therefore, we do not have a significant backlog. In addition, a large
proportion of our sales are concentrated at the end of each quarter. These
factors make it difficult to project our quarterly and annual results of
operations. At the beginning of 2007, we released financial guidance to the
public with respect to the forthcoming year. We intend to continue to release
to the public at the beginning of each year an annual financial guidance.
Should our actual results of operations fall short of our guidance or analysts
estimates, the price of our ordinary shares may decline.

9

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Risks Related to Our Operations in Israel

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

Our
corporate headquarters, manufacturing facilities and principal research and
development facilities are located in Israel. Accordingly, security, political
and economic conditions in Israel may directly affect our business.  Over the past several decades, a number of
armed conflicts have occurred between Israel and its Arab neighbors. Any
hostilities involving Israel or the interruption or curtailment of trade
between Israel and its present trading partners could affect our
operations.  Since September 2000, there
has been a marked increase in violence, civil unrest and hostility, including
armed clashes between the State of Israel and the Palestinian Authority and
other groups in the West Bank and Gaza Strip, and acts of terror have been
committed inside Israel and against Israeli targets in the West Bank and Gaza.
During July and August 2006, major hostilities have broken out between Israel
and both Palestinian factions in Gaza and Hezbollah in Lebanon, leading to an
escalation of the conflict in the area. Major towns and settlements in northern
Israel, including Haifa, Naharia, Safed and Karmiel were under attacks from
Hezbollah missiles. Such conflicts, as well as the internal military conflicts
between the Hamas and Fatah in the Gaza Strip and some parts of the West Bank,
may affect Israels security, foreign relations and the stability of the
region. Increased hostilities, future armed conflicts, political developments
in other states in the region, or continued or increased terrorism could make
it more difficult for us to conduct our operations in Israel, which could increase
our costs and adversely affect our financial results. For example, as many of
our male employees in Israel are obligated to perform annual military reserve
duty typically until 45 years of age and in some cases up to 54 years of age,
any major escalation in hostilities in the region could result in a portion of
our employees being required to perform military duty for an extended period of
time.

In
2005, Israel experienced unionized general strikes in connection with economic
reforms being passed into legislation. In addition, during July and August
2006, Haifa Port was closed as a result of the escalation of the military
conflict in northern Israel. Due to the fact that our products are manufactured
in Israel and, for the most part, sold to customers outside of Israel, a
prolonged general strike or a disruption of any of the Israeli ports for an
extended period of time, would affect our ability to deliver our products to
our non-Israeli customers. We cannot guarantee that a prolonged general strike
in Israel or a disruption of any of the Israeli ports as a result of a military
conflict, would not have a material adverse effect on our business, results of
operations and financial condition.

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

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

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

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

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

10

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|  |                                                                                                                                                                                               
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | bring an original action in an Israeli court against
  us or against any of our executive officers or directors to enforce
  liabilities based upon the United States federal securities laws.

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

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

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

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

We will be exposed to risks relating to evaluations of
controls required by Section 404 of the Sarbanes-Oxley Act of 2002.

Under
the current rules of the Securities and Exchange Commission, or the SEC, we are
required to comply with the management assessment of internal controls over
financial reporting
requirement of Section 404 of the Sarbanes-Oxley Act of 2002 for our fiscal
year ending December 31, 2006 and with the auditor attestation requirement of Section 404 for our fiscal
year ending December 31, 2007. We are in the process of evaluating our internal
controls systems to allow management to report on, and our independent auditors to audit, our
internal controls over financial reporting. We will be performing the system
and process
evaluation and testing (and any necessary remediation) required to comply with
the management assessment and auditor attestation requirements of Section 404. However, we
cannot be certain as to the timing of completion of our evaluation, testing and
remediation actions or the impact of the same on our operations. Furthermore, upon completion of
this process, we may identify control deficiencies of varying degrees of severity under
applicable SEC and Public Company Accounting Oversight Board rules and
regulations that remain unremediated. We will be required to report, among other things, control
deficiencies that constitute a material weakness or changes in internal
controls that, or are reasonably likely to, materially affect internal controls over financial
reporting. A material weakness is a control deficiency, or combination of
control deficiencies that results in more than a remote likelihood that a
material misstatement of the annual or interim financial statements will not be
prevented or detected. If we fail to implement the requirements of Section 404 in a timely manner,
we might be subject to sanctions or investigation by regulatory authorities such as the SEC or by
Nasdaq. Additionally, failure to comply with Section 404 or the report by us of
a material weakness may cause investors to lose confidence in our financial statements and
our share price may be adversely affected. If we fail to remedy any material
weakness, our financial statements may be inaccurate, we may not have access to the capital
markets, and our share price may be adversely affected.

11

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|        |                           
|------- | --------------------------
|Item 4. | INFORMATION ON THE COMPANY

A.                    History and Development of the Company

Our
legal and commercial name is Aladdin Knowledge Systems Ltd. We were
incorporated in Israel in 1985. Our principal executive offices are located at
35 Efal Street, Kiryat Arye, Petach Tikva, Israel 49511, and our telephone
number is 972-3-978-1222. Our agent in the United States is Aladdin Knowledge
Systems Inc., 601 Campus Dr. Ste C-1, Arlington Heights, Illinois 60004, its
telephone number is 1-847-818-3800. Our Internet address is:
http://www.Aladdin.com. Information on our web site is not incorporated by
reference in this annual report.

Capital Expenditures

During
the past three years, our capital expenditures amounted to approximately $2.7
million. Our capital expenditure program primarily included investment in IT
systems, equipment for research and development and testing purposes as well as
general computer software and hardware.
We continue to make capital investments of a similar nature in our
Israeli facilities and also in connection with our production activities.

B.                    Business Overview

We
are a global provider of security solutions that reduce software theft,
strongly authenticate network users and protect against unwanted Internet and
e-mail-borne content, including spam and viruses. We have experienced
significant growth since our founding in 1985. Our products are organized into two segments:
software digital rights management, or DRM, and enterprise security. Our
software DRM solutions allow software publishers to limit revenue loss from
software theft and piracy. Our enterprise security solutions enable
organizations to secure their information technology assets by controlling who
has access to their networks and applications (authentication) and what content
their users can utilize (content security).

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

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

Within
the software DRM market, we provide solutions primarily to the hardware-based
software licensing authentication token, or SLAT, market, which is the largest
segment of the software DRM market. We launched our new generation of HASP,
HASP SRM, in March 2007.  HASP SRM
combines software-based software DRM solution together with hardware-based
solution in a single platform. We anticipate that HASP SRM will increase our
global presence in the software-based software DRM field. We have grown our
customer base through a history of innovation in the security market and have a
broad portfolio of intellectual property, including a number of patents and
patent applications pending.

Industry Background

With
global software piracy, malicious code attacks and unauthorized network access
presenting ever-greater threats, the need for reliable digital security
solutions has never been greater. To combat increasing software piracy,
software publishers are seeking DRM solutions to protect their intellectual
property. Software DRM solutions reduce software piracy by using either
hardware or software-based software protection solutions. To avoid

12

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malicious code attacks and unauthorized network
access, and to enhance enterprise security, organizations are seeking
authentication and content security solutions. Authentication solutions
positively identify users (internally as well as from outside the enterprise)
before granting access to critical applications and resources. Content security
solutions protect networks against viruses, worms, spam and other Internet and
e-mail-borne unwanted content.

Software DRM Overview

The
advancement of digital technologies makes it possible to produce an essentially
perfect copy of any digital asset with minimal effort. Piracy affects all forms
of digital content, such as music, movies, text and software. With the advent
of the personal computer, software piracy first became an issue in the
1980s.  Development of the Internet in
the 1990s virtually eliminated the need for a physical medium to perform
illegal transfers of digital assets.
According to a May 2006  study by
the Business Software Alliance and IDC, software developers lost $34 billion of
potential revenue in 2004 due to software piracy, and in some countries
approximately 90% of all software in use is pirated.  Software piracy impacts software publishers by preventing them
from realizing all of the licensing revenue from the use of their software
products. Software piracy can occur in many forms, including end-users making
unauthorized copies and distributing them to friends or co-workers, retailers
selling illegal copies, computer dealers loading illegal copies onto their
customers hardware, commercial counterfeiters offering illegal copies for sale
and enterprises exceeding the number of users or scope of use authorized by
license agreements.

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

Software DRM market trends

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

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

Enterprise security overview

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

---

13



Authentication overview

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

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

Authentication market trends

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

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

Content security overview

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

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

14

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

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

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

Content security market trends

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

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Messaging security, which is used to monitor, filter
  and block messages from different messaging applications, is projected to
  grow from $665 million in 2004 to $2.6 billion in 2009, representing a
  compound annual growth rate of 31.3%; and                                                                                                                                                                                                            
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Web filtering, which is used to screen and exclude
  web pages which are deemed objectionable or not business related, is
  projected to grow from $433 million in 2004 to $929 million in 2009,
  representing a compound annual growth rate of 16.5%.                                                                                                                                                                                                          
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|  | We believe that the following are key growth drivers
  of the content security market:                                                                                                                                                                                                                                                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Higher frequency of worms and
  viruses. Attacks on
  consumers and corporate users have become easier with the proliferation of
  broadband access. According to Viruslist.com, a website focusing on Internet
  security, the number of new threats continues to grow at the rate of several
  hundred every day.                                                                                                                                              
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Escalation of spyware. Organizations are becoming increasingly
  impacted by spyware, which steals critical information and user identities.
  IDC ranks spyware as the fourth-greatest threat to network security, well
  ahead of spam and even cyber-terrorism.                                                                                                                                                                                               
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Continuation of spam proliferation. According to a February 2006, Ferris
  Research report, spammers send an average of 15 billion spam email messages
  per day. This represents 60% out of a total of 25 billion email messages sent
  per day.                                                                                                                                                                                                                
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Information and identity theft. The widespread use of the Internet for
  e-commerce and e-business has resulted in rapid growth in the number of
  information and identity theft cases. This, in turn, is causing a steadily
  growing awareness of the need for stronger information security. Millions of
  people around the world who use the Internet receive phishing emails, and
  online shoppers lose money as a direct result of phishing. Phishing is

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|  |                                                                                                                                                                                                                                                                                                                                                                                                   
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  | the act of sending an email to a user falsely
  claiming to be from an established, legitimate enterprise, in an attempt to
  lure them into spoofed sites often of those known brands. On those sites,
  users are mislead into surrendering private information that will be used for
  fraud and identity theft, or infected with spying Trojans, password stealers
  and other malicious code.
|  |                                                                                                                                                                                                                                                                                                                                                                                                   
| | Increasing regulation. Regulations such as the Gramm-Leach-Bailey
  Act, HIPAA and SOX, each require enhanced protection of sensitive personal
  and corporate data, thereby forcing organizations to take additional measures
  to protect their networks.                                                                                                                                       

Our Solutions

Software
DRM

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

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------
| | Comprehensiveness and flexibility.
  We provide comprehensive and flexible alternatives for software publishers to
  license their software. Our customers can combine hardware-based,
  software-based and network-based software licensing. Utilizing our Protect
  OnceDeliver Many architecture, software publishers can prepare their
  software for distribution and implement differing licensing models for
  different markets.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
| | Security.Our
  advanced algorithms and anti-debugging features provide enhanced security to
  our customers. The high level of security is achieved through features such
  as:                                                                                                                                                                                                                                                            
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                            | an advanced encryption engine that employs
  state-of-the-art algorithms based on 128 bit Advanced Encryption Standard
  (AES) technology;
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                            | a hardware-based real-time clock, enabling
  time-based licensing and security; and                                                       
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                            | remote software updating using digitally signed
  secure files.                                                                           

We
believe that no competing product offers the combination of such features and
the associated level of security.

|  |                                                                                                                                                                                                                                                                   
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Ease of use.
  Software publishers can protect their products without any special
  programming by applying our proprietary software wrapping technology. For
  end-users, installation of protected software is a simple and transparent
  plug-and-play process.
|  |                                                                                                                                                                                                                                                                   
| | Reliability. We
  believe our hardware keys are reliable even while operating in diverse
  environments. Our product return rate in 2006, like in preceding years, was
  negligible.                                                                              

Enterprise
security

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

Authentication

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Comprehensiveness.
  eToken offers a full strong authentication and password management solution,
  comprised of devices, applications, and a management system. All eToken
  products are interoperable so the solution can be easily adapted to
  customers specific needs.                                                                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | Enhanced security.
  eToken offers smart card based devices which provide highly secure storage of
  encryption keys and credentials as well as on-board cryptographic operations.
  The eToken authentication technology using hardware-based cryptographic
  challenge-response enhances security and is not available in competing
  authentication technologies such as biometrics, passwords and software-based
  tokens, which do not utilize a hardware component.

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|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Cost effectiveness.
  Our advanced USB token implementation provides a cost-effective solution due
  to instant USB connectivity offered by most PCs and laptops today making a
  special separate smart card reader redundant. Our architecture, which is
  based on the standard operating system interfaces, can eliminate the need for
  a back-end server, reducing the cost of implementing the solution. Our
  standard USB token draws its power from the USB port which eliminates the
  need for batteries and enables its use indefinitely unlike competing
  technologies. The result is a highly cost effective solution for implementing
  strong user authentication.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | Product quality and ease of use.
  Years of adaptation to mainstream security applications and rigorous field
  testing, combined with an emphasis on ease of use, has positioned the eToken
  solution as one of the most advanced, robust and simple solutions in the
  market.                                                                                                                                                                                                                                                                                                                                                                                                   

Content
security

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

Our Strategy

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

Extend our technology and introduce new products

We
intend to leverage our technology, product strengths and expertise to further
expand our core product functionality and continue to develop complementary
solutions. We will continue to invest in research and development and expect to
announce several new product and technology offerings during 2007.  Current initiatives include the
following:

|  |                                                                                                                                                                                                                
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | expanding our eToken line of products, including an
  innovative biometric solution, a Java card based token and smart card
  and a new eToken OTP only based device (eToken Pass) for the enterprise
  market;
|  |                                                                                                                                                                                                                
| | introducing a new innovative and powerful
  architecture for Token management system (TMS) and eToken security
  applications;                                                                                 
|  |                                                                                                                                                                                                                
| | completion during 2007 of the certification process
  of the eToken devices according to the Common Criteria and FIPS 140-2 level
  2&3 certifications; and                                                    
|  |                                                                                                                                                                                                                
| | enhancing our offerings to the service providers
  market.                                                                                                                                                     

17

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Provide customer focus to leverage our existing
customer base

We
believe our dedication to customer service has fostered significant loyalty
within our customer base and that a significant portion of our revenues in 2006
were from repeat customers. In the software DRM field, repeat customers
accounted for more than 95% of our sales. In addition, we believe that our established
enterprise security customer base represents a significant opportunity to
cross-sell our other enterprise solutions.

Establish new strategic OEM relationships and other
distribution channels

We
market our enterprise security products, eToken and eSafe, through indirect
channels, including distributors, value-added resellers and system integrators,
and in the last two years, through OEM relationships. We believe that this
strategy allows
us to provide our security solutions to the largest number of end-users. We
intend to increase our channel sales to accelerate the growth of our enterprise
security segment particularly by establishing OEM relationships with large
technology vendors.  For example, in the
first quarter of 2006, we announced an OEM relationship with RSA Security Inc.
for our eToken products which represented a second phase to the patent
licensing agreement we entered into with RSA Security Inc. in January 2005.

Pursue strategic acquisitions

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

Our Products

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

Software
DRM

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

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | HASP HL operates by receiving encrypted strings
  during runtime from the protected application and decrypting them in a way
  which is very difficult to imitate. The encryption/decryption key is vendor unique.
  This encryption key is securely stored in the HASP HL key. Only the specific
  vendors HASP HL keys decrypt correctly the encrypted strings and allow them
  to run properly on the computer. HASP HL also contains the infrastructure and
  tools to create and enforce licensing terms. These enable the creation of a
  wide variety of licensing models such as software subscription, software
  rental, module/feature licensing and trialware.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | HASP HL Net, our most sophisticated hardware-based
  key, protects software developers from theft and misuse of their products in
  the network environment. A single key, connected to any computer on the
  network, protects software against illegal use, limits the number of users
  who can access the application concurrently and controls access to up to 112
  software modules and packages.                                                                                                                                                                                                                                                                   
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | HASP SL is a software-based licensing, software
  protection and distribution system that protects software copyright and
  intellectual property and reduces costs for secure distribution via CD-ROM,
  ESD or peer-to-peer networks.                                                                                                                                                                                                                                                                                                                                                                                                                                    
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | HASP
  SRM launched in March 2007, is a new generation of HASP that combines
  hardware-based and software-based technologies into a single platform, giving
  customers the flexibility of mixing and matching protection strategies across
  their product lines and target markets.                                                                                                                                                                                                                                                                                                                                                                                     

18

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Enterprise
Security

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

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

|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | eToken devices,
  including the eToken NG-OTP, a hybrid token incorporating smart card
  technology with one-time password functionality for authentication in
  detached mode, eToken PRO, a two-factor authenticator that employs a
  readerless smart card and is primarily used for secure network access and
  digital signing, and eToken NG-FLASH that offers the same functionality as
  eToken PRO, with the addition of flash memory for mobile data storage. All
  eToken devices can integrate with proximity technology for secure physical
  access.
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | eToken security
  applications, including software enabling certificate based and one-time-password
  based strong authentication, and password management applications enabling
  secure storage and management of user authentication credentials on-board the
  token.                                                                                                                                                                                                                                                                                         
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | eToken SDK
  (software development kit) is a set of industry standard APIs (application
  programming interfaces) and supporting documentation that enables
  organizations and third-party vendors to develop their own token-based
  security solutions, integrating eToken into their applications.                                                                                                                                                                                                                                                            
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | eToken TMS (token
  management system) is a full system for enterprise-wide life cycle management
  of tokens and their associated security applications. This product supports
  applications including Web access, secure e-mail, data encryption, network
  logon and VPN access. It enables administrator and end users self service
  management capabilities.                                                                                                                                                                                               

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

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

Sales and Marketing

Sales

We
sell our software DRM products primarily to software developers and
distributors. None of our customers accounted for more than 10% of our total
revenues in 2004, 2005 or 2006.

We
market and sell our software DRM solutions directly through our head office in
Israel and through our international subsidiaries, including in the United
States, the United Kingdom, Germany, France, The Netherlands, Spain, Italy,
China and Japan. In addition, we have about 30 distributors covering additional
countries not covered by our subsidiaries. In 2006, we recorded revenues of
approximately $36.0 million, representing 40%of our total revenues from sales
by distributors. Under the terms of our distribution agreements, we generally
grant to one distributor in each particular country or region a non-exclusive
right to market our software DRM solutions for an initial term of one year.
During this period, the distributor is required to meet minimum sales targets
set out in the distribution agreement. Following the expiration of the initial
period, the distribution agreement with each distributor is automatically renewed,
unless we or the distributor give prior written notice. Each distributor is
responsible for preparing and submitting to us for approval a marketing plan
for sales in that distributors sales

19

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territory and for obtaining and maintaining any local
regulatory approvals required to sell our software DRM solutions in that
territory.

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

In
April 2007, The Consortium for Indian Information Technology Education,
referred to as CIITE, selected our eToken authentication solution to secure its
vast network of e-Learning resources throughout India. Over the next three
years, our eToken will be provided to CIITEs students wishing to access the
CIITE Educational Portal. eToken will secure access to online academic
services, including online libraries, video-based learning, and IT-related
texts. CIITEs initiative emphasizes the use of technology among the countrys
current and upcoming generations of young professionals.

In
addition to eToken, we have provided CIITE with eSafe content security solution
and an authentication course - a comprehensive, academic-level DVD training
course detailing authentication and security. This course will be used by
students in CIITE-supported institutes and high-level educational
organizations. Over the last year, the course was adopted to meet special CIITE
requirements.

Marketing

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

|  |                                                                                          
|- | -----------------------------------------------------------------------------------------
| | press releases and press relations management;                                           
|  |                                                                                          
| | industry analyst relations programs;                                                     
|  |                                                                                          
| | direct mail and channel-related campaigns;                                               
|  |                                                                                          
| | e-mail sponsorships and campaigns;                                                       
|  |                                                                                          
| | publication of technical and educational articles in
  industry journals;                
|  |                                                                                          
| | participation in industry trade shows;                                                   
|  |                                                                                          
| | organization of, and participation in, product and
  technology conferences and seminars;
|  |                                                                                          
| | competitive analysis;                                                                    
|  |                                                                                          
| | sales and technical events for channel partners and
  end users;                         
|  |                                                                                          
| | advertising in trade and industry focused magazines;                                     
|  |                                                                                          
| | Internet promotion and advertising;                                                      
|  |                                                                                          
| | production and broadcast of webinars, blogs, and
  other new media;                      
|  |                                                                                          
| | development and distribution of literature about our
  company; and                      
|  |                                                                                          
| | development and ongoing maintenance of our web site,
  intranet and extranet.            

Competition

Software
DRM

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

20

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Enterprise
Security

Authentication. In the strong, or two-factor,
authentication market, our eToken product line competes principally with smart
cards and traditional strong authentication tokens, including OTP tokens, which
are currently the dominant method of strong authentication. In addition, our
eToken product line competes with other USB-based authentication systems. One
of our competitors in the authentication market is EMC Corporation
(formerly RSA Security Inc.)
which holds a dominant position in the traditional authentication token market,
in addition to VASCO Data Security International, Inc. and ActivIdentity Corp.
We have entered into licensing and OEM agreements with RSA Security Inc. Our
principal competitor in the USB-based strong authentication market is SafeNet,
in addition to Gemplus Incorporated S.A. and Eutron SpA. According to a
report of Lazard Capital Markets in November 2006, we accounted for 34% of the
global USB hardware authentication market in 2005, while SafeNet accounted for
25% of the market.

Content
security. Our primary competitors in the content security
market for gateway solutions are BlueCoat, Fortinet and Trend Micro Inc. 
Each of them holds a dominant position in this market. The overall content
security market is characterized by a small number of large companies, such as
Symantec Corporation, McAfee Inc. and Trend Micro, which together in
2005 accounted for over 75% of global revenues in this market, as well as a large number of smaller
companies.

While
a substantial part of the products marketed by these companies are primarily
desktop or network server solutions and not the gateway solution that eSafe
provides, we may face competition from these companies to the extent
that a portion of their product portfolios includes gateway solutions. Vendors
of firewalls might decide to extend their offerings to gateway security, and
these could compete with our eSafe product. In the field of Internet service
providers solutions, we currently face a slight competition, but it may
intensify in the future.

Intellectual Property

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

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

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

We
cannot be certain that any patents, or patents that are advantageous to us,
will be issued.  On January 31, 2005, we
announced that RSA Security Inc. has licensed two of our patents relating to
our eToken technology.  We believe that
this license to a market leader in strong, two factor authentication technology
supports the strength of our intellectual property portfolio in this segment of
our business. We have  26 registered
patents and 54 pending applications in the United States.  We also had 12 registered patents and 58
pending applications outside of the United States.

Government Regulation

Regulation of Encryption Technologies

Our eToken and HASP product lines contain encryption
technologies which require a permit from the Israeli government for their
development and export. We have obtained a general permit for our HASP HL
product, which does not require renewal, and we have a special permit to export
eToken, which requires annual renewal.  The

21

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sale of eToken
in some countries may require special approval by the Israeli government, per
sale, and there can be no guarantee that the Israeli government will provide
such approval. In addition, we may need to apply for additional permits in the
future to export products currently under development that include encryption
technologies. There can be no guarantee that the Israeli government will grant
such permits. Furthermore, the laws or regulations governing the export of
encryption technologies may change and we may be required to comply with more
stringent requirements.  We also conduct
some of our research and development activities in Germany and may be subject
to regulations regarding export of technologies.

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

Environmental Regulation

Our
European activities require us to comply with European Union Directives with
respect to product quality assurance standards and environmental standards.
Directive 2002/95/ec of the European Parliament on the Restriction of the Use
of Certain Hazardous Substances in Electrical and Electronic Equipment (the
RoHS Directive) became effective on July 1, 2006. This directive provides that
producers of electrical and electronic equipment may not place new equipment
containing lead, mercury and certain other materials deemed to be hazardous, in
amounts exceeding the set maximum concentration values, on the market in the
European Union. Certain of our products must be modified to meet this
regulation. Complying with this directive imposes some additional costs and
administrative burden on us.  European
Directive 2002/96/EC on waste, electrical and electronic equipment, known as
the WEEE Directive, makes manufacturers of electrical and electronic equipment
financially responsible for specified collection, recycling, treatment and
disposal of past and future covered products.
The WEEE Directive became effective on August 13, 2005.  We may incur financial responsibility for
the collection, recycling, treatment or disposal of products covered under the
WEEE Directive. Because the EU member states have not fully implemented the
WEEE Directive, the nature and extent of the costs to comply and fees or
penalties associated with noncompliance are unknown at this time. Costs to
comply with the WEEE Directive and similar future legislation, if applicable,
may also include legal and regulatory costs and insurance costs. We may also be
required to take reserves for costs associated with compliance with these
regulations.

Manufacturing

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

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

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

22

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|  |                                                                                                                                                                 
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
| | eSafe- We purchase several models of
  appliances hardware from a single vendor, on which we install eSafe product
  and sell the bundled solution to customers.

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

We
license the anti-spam and web filtering functions incorporated in our eSafe
product pursuant to a license agreement which is automatically renewed for
successive one-year terms, unless a notice of termination is given by either of
the parties prior to the renewal.  We
pay our licensor royalties consisting of a percentage of our revenues from
eSafe. In the event that our licensor cancels this license arrangement with us,
we will be required to seek an alternate licensor for these functions.

C.               Organizational Structure

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

|                                                                        |                           
|----------------------------------------------------------------------- | --------------------------
|Name of
  Subsidiary                                                    | Country of
  Incorporation
|                                                                        |                           
|                                                                        |                           
|Aladdin
  Knowledge Systems, Inc.                                       | United
  States (New York)
|Aladdin
  Japan Co. Inc.                                                | Japan                     
|Aladdin
  Europe Ltd. (formerly Aladdin Western Europe Ltd.)            | England and
  Wales       
|Aladdin
  Knowledge Systems India Pvt (1)                               | India                     
|Aladdin
  Europe BV (formerly Aladdin Western Europe BV) (2)            | The
  Netherlands         
|Aladdin
  Europe S.A.R.L. (formerly Aladdin Western Europe S.A.R.L.)(2) | France                    
|Aladdin
  Knowledge Systems España S.L. (2)                             | Spain                     
|Aladdin
  Europe GmbH (formerly Aladdin Knowledge Systems               | Germany                   
|Deutschland
  GmbH) (2)(3)                                              |                           
|Aladdin
  Knowledge Systems Italy SRL(2)                                | Italy                     

---

|    |                                                                                                                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | 99% of the
  outstanding share capital of this subsidiary is owned by Aladdin Knowledge
  Systems Ltd., and the remaining 1% shareholding is owned by our wholly-owned
  holding company, Hafalad BV, incorporated in The Netherlands.
|    |                                                                                                                                                                                                                                       
|(2) | Halafad BV,
  our wholly-owned holding company, wholly owns this subsidiary.  This subsidiary is involved in
  distribution, support and management of our products.                                                                  
|    |                                                                                                                                                                                                                                       
|(3) | This
  subsidiary provides us with research and development services.                                                                                                                                                                 

We also have a
representative office in China.

D.               Property, Plants and Equipment

In
August 2006, we moved our corporate headquarters and principal research and
development facilities to our new location at Kiryat Arye industrial area in
Petach Tikva, Israel. Our new facilities consist of 49,514 square feet which
are leased for 5 years, with an option to extend for an additional 5
years.  Our manufacturing facility is
located in a 10,521 square foot facility in Kiryat Gat, Israel. We lease this
facility pursuant to a lease agreement that

23

---



expired in
December 2006 and negotiations for the extension of the lease are currently
ongoing.  We also lease an 11,883 square
foot facility in Tirat Hacarmel, Israel used for our content security research
and development activities, for a term expiring in December 2007.

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

Our
aggregate annual lease expenses in 2006 for our facilities were $2.2 million.
We believe that our current facilities together with our new corporate
headquarters and principal research and development facility are adequate for
our current and foreseeable needs.  We
believe we will be able to find alternate facilities if we require them or if
we are unable to renew our existing leases on reasonable terms or at all.

|         |                          
|-------- | -------------------------
|Item 4A. | UNRESOLVED STAFF COMMENTS

Not
applicable.

|        |                                             
|------- | --------------------------------------------
|Item 5. | OPERATING AND FINANCIAL REVIEW AND PROSPECTS

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

Overview

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

We
were established in 1985 with our principal focus on software protection
through our HASP product line.  In the
last decade, we completed five acquisitions of businesses and product lines
which broadened our product offering and enhanced our research and development,
direct marketing and selling capabilities. We acquired our eSafe product line
at the end of 1998. In 1999, we penetrated the enterprise security market by
complementing eSafe with our eToken product line. As a result of the additional
expenses incurred in this transition, as well as generally adverse economic
conditions, we incurred net losses in 2001 and 2002. In 2003 and subsequent
interim periods, we returned to profitability. At the beginning of 2004, we
constituted our enterprise security segment as a separate reportable segment.
In 2006, we generated 68% of our revenues from our software DRM segment and the
rest from our enterprise security segment. All of our profits in 2006 were
derived from our software DRM products.

Reportable
segments

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

|                      |  |                         |  |      |  |      | 
|--------------------- |  | ----------------------- |  | ---- |  | ---- | 
|                      |  | Year ended December 31, | 
|                      |  | 2004                    |  | 2005 |  | 2006 | 
|Software DRM          |  | 73%                     |  | 69%  |  | 68%  | 
|Enterprise
  security |  | 27%                     |  | 31%  |  | 32%  | 

24

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Revenues

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

In
2005 and 2006, part of our revenues was denominated in euros, Japanese Yen and
British pounds.  When translating these
revenues into U.S. dollars for the purposes of preparing our consolidated
financial statements, our reported revenues are affected.  In our period to period discussion below, we
have indicated the effects of currency fluctuations on our revenues in our
reported segments. We also refer you to Item 11. Quantitative and Qualitative
Disclosures About Market Risk below for disclosure of the effect of changes in
exchange rates on our overall revenues, gross profit and operating income for
the years ended December 31, 2004, 2005 and 2006.

Revenue
recognition

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

Software
licenses.We enter into perpetual licenses and, in
some cases, time-based licenses, with purchasers of eSafe. Time-based licenses
are mostly for one or two-year periods with respect to additional
functionalities of eSafe, such as anti-spam, web and application filtering.
License fees are recognized when persuasive evidence of an agreement exists,
delivery of the product has occurred, no significant obligations with regard to
implementation remain, the fee is fixed or determinable and collectibility is
probable.

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

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

Deferred
revenues include unearned amounts received from maintenance and support
contracts.

Our
deferred revenues as of December 31, 2005 and 2006 were $5.6 million and $6.2
million; respectively. The increase was primarily due to an increase in
time-based license revenues.

Revenue trends and
drivers

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

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

25

---



|                             |  |                         |     |      |  |      |   |  |     |  
|---------------------------- |  | ----------------------- | --- | ---- |  | ---- | - |  | --- | -
|                             |  | Year ended December 31, |    
|                             |  |                         |     |      |  |      |   |  |     |  
|                             |  | 2004                    |     | 2005 |  | 2006 |  
|United
  States              |  |                         | 29  | %    |  | 33   | % |  | 26  | %
|Europe
  (excluding Germany) |  |                         | 27  |      |  | 26   |   |  | 30  |  
|Germany                      |  |                         | 22  |      |  | 21   |   |  | 22  |  
|Japan                        |  |                         | 13  |      |  | 11   |   |  | 10  |  
|Israel                       |  |                         | 3   |      |  | 4    |   |  | 5   |  
|Others                       |  |                         | 6   |      |  | 5    |   |  | 7   |  
|                             |  |                         |     |      |  |      |   |  |     |  
|Total                        |  |                         | 100 | %    |  | 100  | % |  | 100 | %
|                             |  |                         |     |      |  |      |   |  |     |  

Repeat
customers.We consider the proportion of our revenues
from repeat customers to be an important tool in analyzing our business in our
software DRM segment. We believe that a significant portion of our revenues in
2006 was from repeat customers.

Cost of revenues and gross profit

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

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

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

Operating
expenses

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

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

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

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

Taxes
on income.Although Israeli companies were generally
subject to income tax at the corporate rate of 31% in 2006, we benefit from
Israeli government tax exemption programs that reduce our effective tax rate as
described under the caption Corporate Tax.

26

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Critical Accounting
Policies and Estimates

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

Allowance for doubtful accounts

We
are required to perform ongoing credit evaluations of our trade receivables and
maintain an allowance for doubtful accounts, based upon our judgment as to our
ability to collect outstanding receivables. Provisions are made based upon a
specific review of all the outstanding invoices. In determining the provisions,
we analyze our historical collection experience, current economic trends and
the financial position of our customers. If the financial condition of our
customers deteriorates, our revenues might be limited and additional allowances
might be required. As of December 31, 2006, our allowance for doubtful accounts
was $274,000 and our trade receivables were $16.4 million.

Inventories

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

SFAS 123(R)

On
January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123
(revised 2004), Share-Based Payment, referred to as SFAS 123(R), which
requires the measurement and recognition of compensation expense based on
estimated fair values for all share-based payment awards made to employees and
directors. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, or APB 25, under which we
previously accounted for our share based awards granted to employees and
directors. In March 2005, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 107, or SAB 107, relating to SFAS 123(R). We have
applied the provisions of SAB 107 in our adoption of SFAS 123(R).

SFAS
123(R) requires companies to estimate the fair value of equity-based payment
awards on the date of grant using an option-pricing model. The value of the
portion of the award that is ultimately expected to vest is recognized as an
expense over the requisite service periods in our consolidated income
statement. Prior to the adoption of SFAS 123(R), we accounted for equity-based
awards to employees and directors using the intrinsic value method in
accordance with APB 25 as allowed under Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation, or SFAS 123.   Our determination of fair value of
share-based payment awards on the date of grant using an option-pricing model
is affected by our stock price as well as assumptions regarding a number of
highly complex and subjective variables.
These variables include, but are not limited to our expected stock price
volatility over the terms of the awards, and actual and projected employee
stock option exercise behaviors.
Although the fair value of employee stock options is determined in
accordance with SFAS 123(R) and SAB 107 using an option-pricing model, that
value may not be indicative of the fair value observed in a willing
buyer/willing seller market transaction.

We
adopted SFAS 123(R) using the modified prospective transition method, which
requires the application of the accounting standard starting from January 1,
2006, the first day of our fiscal year 2006. Under that transition

27

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method,
compensation cost recognized in 2006, includes: (a) compensation cost for all
share-based payments granted prior to, but not yet vested as of January 1,
2006, based on the grant date fair value estimated in accordance with the
original provisions of SFAS 123; and (b) compensation cost for all share-based
payments granted subsequent to January 1, 2006, based on the grant-date fair
value estimated in accordance with the provisions of SFAS 123(R). Results for
prior periods have not been restated.

We
recognize compensation expenses for the value of our awards, which have graded
vesting, based on the accelerated attribution method over the vesting period,
net of estimated forfeitures. Estimated forfeitures are based on actual
historical pre-vesting forfeitures.

As
a result of adopting SFAS 123(R) on January 1, 2006, our income before taxes
    in 2006, was $2.3 million lower than we had continued to account for
stock-based compensation under APB 25. Basic and diluted net earnings per share
for 2006, were both $0.15 lower than if we had continued to account for
share-based compensation under APB 25.

Taxes on income and deferred tax

We
account for income taxes using the asset and liability method. Deferred tax
assets net of valuation allowances, totaled $3.1 million as of December 31,
2006. Deferred tax assets, related valuation allowances and deferred tax
liabilities are determined separately by each tax jurisdiction. We believe that
sufficient uncertainty exists regarding our ability to realize our deferred tax
assets in certain foreign jurisdictions and, accordingly, a valuation allowance
has been established against the deferred tax assets in those jurisdictions. We
believe that it is more likely than not that the results of future operations
will generate sufficient taxable income to utilize the remaining deferred tax
assets, net of valuation allowances. While we have considered future taxable
income and ongoing tax planning strategies in assessing the need for any
valuation allowance, in the event we were to determine that we will be able to
realize our deferred tax assets in the future in excess of the net recorded
amount, an adjustment to the valuation allowance would increase income in the
period such a determination is made. Likewise, should we determine that we
would not be able to realize all or part of our net deferred tax assets in the
future, an adjustment to the valuation allowance would be charged to income in
the period such a determination is made. Our effective tax rate is directly
affected by the relative proportions of revenue and income before taxes
generated in different tax jurisdictions, as well as the estimated level of
annual pre-tax income. We are also subject to changing tax laws in the multiple
jurisdictions in which we operate.

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

Goodwill

Under
Statement of Financial Accounting Standard No. 142, Goodwill and Other
Intangible Assets, or SFAS 142, goodwill acquired in a business combination
is deemed to have indefinite life and will
not be amortized. SFAS 142 requires goodwill to be tested for impairment on
adoption and at least annually thereafter or between annual tests in certain
circumstances, and written down when impaired. Goodwill is tested for
impairment by comparing the fair value of each reporting units with its
carrying value. Our reporting units for purposes of the impairment test are our
two operating segments, the software security DRM, and enterprise security.
Fair value is determined for each reporting unit by estimating the present
value of the reporting units future cash flows. If the fair value exceeds the
carrying value, no impairment loss is recognized. Significant estimates used in
the methodologies included estimates of future cash flows and estimates of
discount rates.  As of December 31,
2006, we had total goodwill of $7.7 million on our balance sheet. We perform
the annual impairment tests during the fourth quarter every year and no
impairment losses were identified.  In
assessing the recoverability of our goodwill, we must make assumptions
regarding the estimated future cash flows and other factors to determine the
fair value of the respective assets. If these estimates or their related
assumptions change in the future, we may be required to record impairment
charges for these assets.

28

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Intangible Assets

Intangible
assets acquired are amortized over their useful life using a method of
amortization that reflects the pattern in which the economic benefits of the
intangible assets are consumed or otherwise used up, in accordance with SFAS
142. Indefinite-lived intangible assets are not amortized, but rather are subject
to an annual impairment test. Other intangible assets are amortized using the
straight-line method over the estimated useful life, as described below.

Impairment of long-lived assets

Under
Statement of Financial Accounting Standard No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, long-lived assets, such as
property and equipment, and purchased intangibles subject to amortization, are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset group may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison of the
carrying amount of an asset group to estimated undiscounted future cash flows
expected to be generated by the asset group. If the carrying amount of an asset
group exceeds its estimated future cash flows, an impairment charge is
recognized in the amount by which the carrying amount of the asset group
exceeds the fair value of the asset group. Assets to be disposed of would be
separately presented on the balance sheet and reported at the lower of the
carrying amount or fair value less costs to sell, and would no longer be
depreciated. The assets and liabilities of a disposal group classified as held
for sale would be presented separately in the appropriate asset and liability
sections of the balance sheet. In 2004, 2005 and 2006, we have not recorded
impairment charges for long-lived assets.

Investment in other companies

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

During
2006, we invested in Athena Smartcard Solution Ltd. (Athena), a Japanese
company and an expert in developing smart card systems. The investment in this
company, in which we hold 23.5% as of December 31, 2006, is being accounted using
the equity method.

Impact of recently issued accounting
standards

In
July 2006, the FASB issued FASB Interpretation 48, Accounting for Income
Tax Uncertainties, referred to as FIN 48. FIN 48 defines the threshold
for recognizing the benefits of tax return positions in the financial statements
as
more-likely-than-not to be sustained with the taxing authority. The
recently issued literature also provides guidance on derecognition, measurement
and classification of income tax uncertainties, along with any related interest
and penalties. FIN 48 also includes guidance concerning accounting for income
tax uncertainties in interim periods and increases the level of disclosures
associated with any recorded income tax uncertainties. FIN 48 is effective for
fiscal years beginning after December 15, 2006. The differences between the
amounts recognized in the statements of financial position prior to the
adoption of FIN 48 and the amounts reported after adoption will be accounted
for as a cumulative-effect adjustment recorded to the beginning balance of
retained earnings. The adoption of FIN 48 has insignificant impact on our
consolidated financial statements in the total amount of $ 182,000.

In
September 2006, FASB issued SFAS No. 157, Fair Value Measurements, referred
to as SFAS 157. SFAS 157 defines fair value, establishes a framework for
measuring fair value in generally accepted accounting principles and expands
disclosures about fair value measurements. SFAS 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007 and
interim periods within those fiscal years whether we will choose to apply SFAS
No. 159  The Fair Value Option for Financial Assets and Financial Liabilities,
or SFAS 159, than the influence of SFAS 157 may be material.

29

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In
February 2007, the FASB issued SFAS 159. SFAS 159 permits companies to choose
to measure certain financial instruments and certain other items at fair
value.  SFAS 159 requires that
unrealized gains and losses on items for which the fair value option has been
elected be reported in earnings.  SFAS
159 is effective for financial statements issued for fiscal years beginning
after November 15, 2007 and interim periods within those fiscal years, although
earlier adoption is permitted. We are currently evaluating the impact that SFAS
159 will have on our consolidated financial statements.

Litigation

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

Results of
Operations

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

|                              |  |                         |       |      |  |       |   |  |       |  
|----------------------------- |  | ----------------------- | ----- | ---- |  | ----- | - |  | ----- | -
|                              |  | Year ended December 31, |      
|                              |  | 2004                    |       | 2005 |  | 2006  |  
|                              |  |                         |       |      |  |       |  
|Revenues:                     |  |                         |       |      |  |       |   |  |       |  
|Software security             |  |                         | 73.3  | %    |  | 69.2. | % |  | 68.0. | %
|Enterprise security           |  |                         | 26.7  |      |  | 30.8  |   |  | 32.0  |  
|                              |  |                         |       |      |  |       |   |  |       |  
|Total revenues                |  |                         | 100.0 |      |  | 100.0 |   |  | 100.0 |  
|Cost of revenues:             |  |                         |       |      |  |       |   |  |       |  
|Software security             |  |                         | 13.8  |      |  | 12.1  |   |  | 10.5  |  
|Enterprise security           |  |                         | 6.1   |      |  | 8.7   |   |  | 12.0  |  
|                              |  |                         |       |      |  |       |   |  |       |  
|Total cost of revenues        |  |                         | 19.9  |      |  | 20.8  |   |  | 22.5  |  
|Gross profit                  |  |                         | 80.1  |      |  | 79.2  |   |  | 77.5  |  
|Operating expenses:           |  |                         |       |      |  |       |   |  |       |  
|Research and development      |  |                         | 17.4  |      |  | 14.8  |   |  | 16.1  |  
|Selling and marketing         |  |                         | 35.7  |      |  | 33.0  |   |  | 32.2  |  
|General and administrative    |  |                         | 12.7  |      |  | 13.7  |   |  | 14.4  |  
|One-time lawsuit charge       |  |                         |      |      |  | 2.4   |   |  |      |  
|                              |  |                         |       |      |  |       |   |  |       |  
|Total operating expenses      |  |                         | 65.8  |      |  | 63.9  |   |  | 62.7  |  
|                              |  |                         |       |      |  |       |   |  |       |  
|Operating income              |  |                         | 14.3  |      |  | 15.3  |   |  | 14.8  |  
|Financial income, net         |  |                         | 0.1   |      |  | 1.3   |   |  | 3.7   |  
|Other income (expenses), net  |  |                         | (0.2  | )    |  | 0.0   |   |  | 0.3   |  
|                              |  |                         |       |      |  |       |   |  |       |  
|Income before taxes on income |  |                         | 14.2  |      |  | 16.6  |   |  | 18.8  |  
|Taxes on income               |  |                         | 1.4   |      |  | 1.5   |   |  | 3.0   |  
|                              |  |                         |       |      |  |       |   |  |       |  
|Net income                    |  |                         | 12.8  | %    |  | 15.1  | % |  | 15.8  | %

Year ended December
31, 2006 compared to year ended December 31, 2005

Revenues

Total
revenues increased by 8.9% to $89.0 million in 2006 from $81.8 million in 2005.

Software
DRM.Revenues from software DRM increased by 7.0% to
$60.6 million in 2006 from $56.6 million in 2005. This increase was
attributable to increased HASP sales in our international markets, mainly in
Europe and APAC.

30

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Enterprise
security.Revenues from enterprise security increased
by 13.0% to $28.5 million in 2006 from $25.2 million in 2005. This increase was
attributable to a 16.3% increase in eToken sales mainly in Europe, APAC and the
Middle east and a 9.0% increase in eSafe sales, mainly in Europe, the Middle
East and South America.

Cost of revenues

Total
cost of revenues increased by 17.9% to $20.0 million in 2006 from $17.0 million
in 2005.

Software
DRM.Cost of revenues for software DRM decreased by
5.9% to $9.3 million in 2006 from $9.9 million in 2005. This decrease was
primarily attributable to a decrease in subcontracting and overhead costs, due
to our increased manufacturing efficiency resulting from our accumulated
experience with our products. Gross margin from software DRM products increased
to 84.7% in 2006 compared to 82.5% in 2005.

Enterprise
security.Cost of revenues for enterprise security
increased by 51.0% to $10.7 million in 2006 from $7.1 million in 2005. This
increase was attributable to the increase in sales of our enterprise security
products. Gross margin from enterprise security decreased to 62.4% in 2006
compared to 71.8% in 2005. This decrease was mainly attributable to several
deals we had in the Asia-Pacific region that were conducted at a low gross
margin in order to penetrate this market. In addition, in 2005, we received a
certain payment for licensing fees from one of our customers with respect of
which we had no cost of revenues. We have not received any similar payment in
2006.

Gross
profit increased by 6.5% to $69.0 million in 2006 from $64.8 million in 2005.
Our gross margin decreased to 77.5% in 2006 from 79.2% in 2005.

Research and development

Research
and development expenses increased by 18.2% to $14.3 million in 2006 compared
to $12.1 million in 2005, representing 16.1% of revenues in 2006 compared to
14.8% in 2005. This increase was primarily attributable to a significant
increase in the eToken research and development activity and to an increase of
$666,000 of stock based compensation expenses as a result of adopting SFAS
123(R).

Selling and marketing

Selling
and marketing expenses increased by 6.5% to $28.7 million in 2006 from $27.0
million in 2005. This increase was mainly attributable to the increase of
$717,000 of stock based compensation expenses as a result of adopting SFAS
123(R). As a percentage of revenues, selling and marketing expenses were stable
at 32.2% in 2006 compared to 33.0% in 2005.

General and administrative

General
and administrative expenses increased by 14.4% to $12.8 million in 2006 from
$11.2 million in 2005. This increase was primarily attributable to an increase
in compensation expenses mainly $845,000 of stock based compensation expenses
as a result of adopting SFAS 123(R).  As
a percentage of revenues, general and administrative expenses increased to
14.4% in 2006 from 13.7% in 2005.

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

Financial income, net

Financial
income, net, in 2006 was $3.2 million compared to financial income, net, of
$1.0 million in 2005. This increase was primarily attributable to interest
income earned on the proceeds from our secondary offering consummated in 2005,
net of losses resulting from currency fluctuations.

31

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Taxes on income

Taxes
on income were $2.7 million in 2006 compared to $1.2 million in 2005.  In 2006, taxes on income in the amount of
$2.8 million were partially offset by an increase in the deferred tax asset of
$124,000 related to certain foreign net operating losses carried forward and
other timing differences.

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

Revenues

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

Software
DRM.Revenues from software DRM increased by 11.7% to
$56.6 million in 2005 from $50.6 million in 2004. This increase was
attributable to increased sales of our HASP products in all geographic markets.

Enterprise
security.Revenues from enterprise security increased
by 36.4% to $25.2 million in 2005 from $18.5 million in 2004. This increase was
mainly attributable to an 85.6%, or $6.5 million, increase in eToken sales.
This increase is also attributable to income from the patent license agreement
with RSA Security.

Cost of revenues

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

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

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

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

Research and development

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

Selling and marketing

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

General and administrative

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

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

Financial income, net

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

Taxes on income

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

Liquidity and
Capital Resources

Our
primary sources of liquidity are our cash, cash equivalents and marketable
securities and our cash flow from operations. In 2005, we also had proceeds
from our secondary offering completed on March 30, 2005. This underwritten
public offering of 2,000,000 ordinary shares resulted in net proceeds to us of
$38.8 million after deducting the underwriting discount and offering expenses.  As of December 31, 2006, we had cash, cash
equivalents and marketable securities aggregating $90.9 million.

On
April 1, 2007, our board of directors authorized the use of our available cash
for the repurchase of Aladdins ordinary shares. According to the terms
of the buy-back program approved by the board, we are authorized to repurchase
Aladdins ordinary shares utilizing up to $10 million or to repurchase such
number of ordinary shares not to exceed 500,000 shares. On June 11, 2007, our
board of directors increased the extent of the buy-back program by an
additional $10 million. The combined total authorization now stands at $20
million. As of June 20, 2007, we repurchased 464,973 shares utilizing
approximately $10 million.

Under
the buy-back program, we are authorized to repurchase Aladdins shares,
from time to time, in the open market, based on market conditions, share price
and other factors. Purchases are made in compliance with the applicable provisions
of Section 302 of the Israeli Companies Law, 1999, the applicable provisions
of Rule 10b-18 of the Securities Exchange Act of 1934, as amended, referred to
as the Exchange Act, and Regulation M promulgated under the Exchange Act. In
accordance with the Israeli law, shares purchased by us under the buy-back program
do not confer upon us any voting rights (although they entitle Aladdin to participation
rights upon distribution).

Our
operating activities provided cash in the amount of $18.9 million in 2006 and
$14.6 million in 2005. The major contributing factors were higher net income
    excluding stock based compensation expenses, offset by an increase in accounts
    receivable, mainly attributed to the increase in revenues. Our operating
    activities provided cash in the amount of $14.6 million in 2005 compared
    to $8.8 million in 2004. In 2005, our cash generated from operating activities
    was impacted by higher net income, an increase in other current liabilities,
    trade payables and deferred revenues, which was partially offset by an increase
    in trade receivables and inventory. The increase in other current liabilities
    was mainly attributable to an increase in our current tax liability. The
    increase in deferred revenues, trade receivables and inventory was primarily
due to the increase in our revenues in 2005 compared to 2004.

Our
investing activities used cash in the amount of $8.5 million in 2006, mainly
consisting of investments in available-for-sale marketable securities less
proceeds in the amount of $2.1 million, investment in other assets in the amount
    of $2.5 million and the purchase of property and equipment in the amount
    of $4.6 million, offset by proceeds from return on investment of other companies,
net of investment in other companies, in the amount of $0.6 million. Our investing activities used cash in the amount of $42.7
    million in 2005 mainly consisting of an investment in available-for-sale
    marketable securities in the amount of $40.5 million and the purchase of
    property and equipment in the amount of $2.3 million. Our investing activities
    used cash in the amount of $13.6 million in 2004, mainly due to the acquisition
    of our former distributor, Aladdin Knowledge España S.L., in the
amount of $1.8 million (net of cash on hand), an investment in Tamir Fishman
Ventures II LLC in the amount of $1.3 million, an investment in IDesia Ltd. in
the amount of $1.1 million, an investment in

33

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available-for-sale
marketable securities in the amount of $7.0 million, the purchase of property
and equipment in the amount of $1.2 million and the purchase of intangible
assets in the amount of $1.2 million.

Our
financing activities provided cash in the amount of $0.8 million in 2006
resulting from proceeds from exercises of stock options by employees. In 2005
and 2004, our financing activities provided cash in the amount of $39.3 million
and $3.6 million, respectively, resulting mainly from proceeds from issuance of
shares in 2005 and proceeds from the exercise of stock options by employees in
2004.

We
had working capital of $100.0 million as of December 31, 2006, $85.0 million as
of December 31, 2005 and $34.1 million as of December 31, 2004.

The
following table summarizes our contractual obligations and commercial
commitments as of December 31, 2006:

|                                  |  |                       |        |                      |   |           |  |           |       |           |   |                 |  |   |       |  |   |     | 
|--------------------------------- |  | --------------------- | ------ | -------------------- | - | --------- |  | --------- | ----- | --------- | - | --------------- |  | - | ----- |  | - | --- | 
|                                  |  | Payment due by period |       
|Contractual obligations           |  | Total                 |        | Less
  than 1
  year |   | 2
  years |  | 3
  years |       | 4
  years |   | After 4
  years | 
|                                  |  |                       |       
|                                  |  | (in thousands)        |       
|Operating
  leases (1)            |  | $                     | 9,539  |                      | $ | 3,166     |  | $         | 2,378 |           | $ | 1,825           |  | $ | 1,257 |  | $ | 913 | 
|Purchase
  obligations (2)        |  |                       | 1,836  |                      |   | 1,836     |  |           |      |           |   |                |  |   |      |  |   |    | 
|Other
  long-term commitments (3) |  |                       | 428    |                      |   | 428       |  |           |      |           |   |                |  |   |      |  |   |    | 
|                                  |  |                       |        |                      |   |           |  |           |       |           |   |                 |  |   |       |  |   |     | 
|Total
  contractual obligations   |  | $                     | 11,803 |                      | $ | 5,430     |  | $         | 2,378 |           | $ | 1,825           |  | $ | 1,257 |  | $ | 913 | 

---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Consists of operating leases for our facilities and for vehicles.                                                                                                                                                                                                                                                                                                                                                                                          
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|(2) | Consists of purchase orders for components for our products. In some
  cases, we are entitled to terminate our commitment upon agreed advance
  notice, which is subject to a penalty.                                                                                                                                                                                                                                                                     
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|(3) | In 2000, we signed an agreement with Tamir Fishman Ventures
  Management II Ltd. and Tamir Fishman Ventures II LLC pursuant to which we
  committed to invest up to $8.5 million (of which $8.1 million had been
  invested by December 31, 2006) in Tamir Fishman Ventures II LLC at their
  request. We based our assumption of the timing of future investments based on
  our past experience, since we cannot foresee when the demands will be placed.

The table
    does not include our
obligation  accrued severance pay under Israels Severance Pay Law, 1963,
which as of December 31, 2006 was $3.4 million, of which $2.7 million was funded
through deposits into severance pay funds, leaving a net obligation of $700,000.

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

Investments

In
April 2004, we entered into a convertible loan agreement with IDesia Ltd., an
Israeli company engaged in the development of biometric identity recognition
technology. Pursuant to the agreement, we invested an aggregate amount of $1.1
million in IDesia Ltd. In addition, we incurred expenses in the amount of
$50,000 in connection with this investment.
This investment consisted of a $550,000 convertible loan, which was
automatically converted into series A preferred shares of IDesia Ltd. upon the
achievement of certain agreed upon milestones.
Concurrently with the conversion of the loan, we invested the remaining
$500,000 by purchasing additional series A preferred shares of IDesia Ltd.

In
October 2005, we signed an agreement titled License and OEM Agreement with IDesia Ltd.  Under this agreement, IDesia Ltd.
will develop, manufacture,
provide and license to us certain chip-sets for the

34

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implementation
of biometric technology as specified in the agreement.  According to the agreement, we made to
IDesia Ltd. an advance payment in the amount of $200,000 in consideration for
the committed chip-sets.

As
of December 31, 2006, we invested an aggregate amount of $8.1 million in two investment
funds managed by Tamir Fishman Ventures Management II Ltd.  We have no control over the operating and
financial policies of these funds. In 2002, we recorded an impairment charge of
$1.0 million related to these investments.

In
2005 and 2006, as a result of exit transactions of portfolio companies of Tamir
Fishman, we received cash distributions of $910,000 and $1.7 million,
respectively. The proceeds received from these cash distributions were recorded
    as a return of investment.

In
November 2006, we entered into an agreement with K.K. Athena Smartcard
Solutions Ltd., a Japanese company, referred to as Athena, whereby we were
granted an option allowing us to invest up to $745,000 in Athena at any time
until June 30, 2007, in consideration for the issuance of shares of
Athena.  The option was exercised in
three installments of $248,000 each, in November 2006, January 2007 and April
2007.

We
had invested in Athena previously but Athena has incurred losses over the years
and we reduced our investments and loans in Athena to zero in 2004. Following a
reconsideration of our management, we decided to reinvest in Athena as
described above.

Corporate Tax

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

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

As
of December 31, 2006, the net operating loss carry-forwards of our subsidiaries
for tax purposes amounted to $26.9 million, the majority of which related to
our United States and German subsidiaries. A subsidiarys net operating loss
carry-forwards for tax purposes relating to a jurisdiction are generally
available to offset future taxable income of such subsidiary in that
jurisdiction, subject to applicable expiration dates.

35

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|        |                                           
|------- | ------------------------------------------
|Item 6. | DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES

A.               Directors and
Senior Management

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

|                          |     |  |                                                    
|------------------------- | --- |  | ---------------------------------------------------
|Name                      | Age |  | Position                                           
|Jacob
  (Yanki) Margalit  | 44  |  | Chairman of
  the Board and Chief Executive Officer
|Aviram
  Shemer           | 37  |  | Chief
  Financial Officer                          
|Elinor
  Nissensohn       | 33  |  | Vice
  President, Global Sales and Marketing       
|David
  Assia(1)          | 55  |  | Director                                           
|Menahem
  Gutterman(1)(2) | 67  |  | Director                                           
|Orna
  Berry(1)(2)        | 57  |  | Director                                           
|Dany
  Margalit           | 40  |  | Director                                           

|    |                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------
|(1) | Member of the audit committee and independent director under The
  Nasdaq Global Market listing requirements.
|(2) | Outside director under the Israeli Companies Law.                                                            

Jacob
(Yanki) Margalitfounded our company in 1985 and has
served as our chairman of the board and chief executive officer since 1987. Mr.
Margalit served as our chief financial officer from 1987 to 1993 and has served
as a director since 1985. Jacob Margalit is the brother of Dany Margalit.

Aviram
Shemerwas appointed as our chief financial officer in
January 2007. Prior to that, during 2006, Mr. Shemer served as the chief
financial officer of PowerDsine Ltd., a developer of power over ethernet (PoE)
solutions recently acquired by Microsemi Corporation. In 2006, Mr. Shemer also
served as vice president, finance of Alvarion Ltd., a provider of wireless
broadband solutions and specialized mobile networks. From 1999 until 2005, Mr.
Shemer served at Aladdin in various positions, including serving as vice
president, finance in 2005. Mr. Shemer holds a B.A. in accounting and economics
and an MBA with a specialization in finance and accounting from the Tel Aviv
University.

Elinor Nissensohn has served as our global
vice president of sales and marketing since July 2006. Ms. Nissensohn began
working in our company in January 2003 as our business development manager. In
July 2004, she was appointed as our customer relations manager and in March
2005, Ms. Nissensohn became vice president of customer relations. Ms.
Nissensohn had previously worked for IBM Corp., Bezeq - Israel Telecommunications
Company, the leading Israeli phone service provider, and Motorola
Semiconductor. Ms. Nissensohn holds an LLB from Tel Aviv University and an MBA
from Columbia Business School. Ms. Nissensohn is also admitted to the Israeli
Bar.

David  Assiahas served as
a director since 1993. Mr. Assia is a co-founder of Magic Software Enterprises
Ltd., a provider of development and integration technology, and Formula Vision
Technologies (F.V.T.) Ltd. (formerly
known as Mashov Computers Ltd.), a software holding company. Mr. Assia
currently serves as the executive chairman of Magic. From 1983 to 1996, Mr.
Assia was the chief executive officer and chairman of Magic. Mr. Assia is also
a member of the boards of directors of Radview Software Ltd., a developer of
verification software, RRSat Global Communications Network Ltd. a provider of
end to end transmission services to the television and radio industries, and
the Weizmann Institute of Science. Mr. Assia holds a B.A. in economics and
statistics and an M.B.A. from Tel Aviv University.

Dr.
Menahem Guttermanhas served as one of our outside
directors since 2000. Since January 2005, Dr. Gutterman has been the deputy
president for research, development and relations with industry of AFEKA  Tel-Aviv
Academic College of Engineering.  From
2001 until January 2005, Dr. Gutterman was a senior managing partner of Atid
Capital Partners, an American/Israeli venture capital fund. Dr. Gutterman has
served as executive vice president and head of the operations information
systems division of Israel Discount Bank Ltd. from 1992 until 2001. Until 2000,
Dr. Gutterman served as a senior lecturer at Tel Aviv University, Faculty
Management, and School of Business Administration. Dr. Gutterman holds a D.Sc.
in mathematics from The Technion-Israel Institute of Technology.

36

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

Dany
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 and
served in this position until 1998. From 1998 until April 2006, Mr. Margalit
served as our executive vice president, technologies.  As of April 2006, Mr. Margalit serves as an advisor to the
Company.  Mr. Margalit holds a B.Sc. in
mathematics and computer science from Tel Aviv University. Dany Margalit is the
brother of Jacob Margalit.

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

B.               Compensation

For
the year ended December 31, 2006, we paid in the aggregate approximately $1.8
million as direct remuneration to our directors and executive officers. This
amount includes directors fees and expenses, but does not include amounts
expended by us for automobiles made available to our officers, expenses
reimbursed to officers (including business travel, professional and business
association dues and expenses) and other fringe benefits commonly reimbursed or
paid by companies in Israel.

The
compensation paid to our directors, including to our directors who also serve
as executive officers, is subject to our audit committee, board of directors
and shareholder approval.

Outside
Directors.We reimburse our outside directors at the
maximum amount permitted under the Companies Regulations (Rules for the Payment
of Remuneration and Expenses of Outside Directors) 2002, which currently
include the following amounts:

| |      |                                                                                                                                              
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------
| | (i)  | an annual
  cash remuneration of NIS 42,245; and                                                                                             
| |      |                                                                                                                                              
| | (ii) | participation
  fees of NIS 1,625 for every meeting of the board of directors or its
  committees in which the outside directors participate.
| |      |                                                                                                                                              

The abovementioned amounts are linked to
  the Israeli consumer price index in accordance with the regulations.

In
addition, we granted to each of our outside directors options to purchase
12,000 ordinary shares under the Companys Worldwide 2003 Share Option Plan,
for each three-year term of service. The exercise price per share equals to the
closing price of our ordinary shares on The Nasdaq Global Market on the last
day of trading prior to the approval of the grant by the shareholders meeting.
The options vest in three installments at the end of each of the three years of
service, subject to the outside directors continued service as an outside
director at each of these dates.

Non-employee
directors.We reimburse our non-employee directors,
which currently include Mr. David Assia and Mr. Dany Margalit, in the same
amounts approved for our outside directors. Mr. Margalit is entitled to such
compensation as of October 1, 2006.

Jacob
(Yanki) Margalit. Effective October 2002, the annual
base salary of Jacob (Yanki) Margalit, our chairman and chief executive
officer, is $150,000. In addition, since the first quarter of 2002, Mr.
Margalit has received an annual performance-based bonus equivalent to 1.5% of
year-to-year increases in our annual revenues. Since the first quarter of 2002,
Mr. Margalit also has received a quarterly performance-based bonus equivalent
to

37

---



3.0% of our
quarterly net profits. Under this arrangement, in 2006, Mr. Margalit was
entitled to a cash bonus in the amount of $ 530,000.  In April 2003, we granted to Mr. Margalit options to purchase
100,000 of our ordinary shares at an exercise price per share of $1.20,
representing a discount of $1.47 to the last reported sale price of our
ordinary shares on The Nasdaq Global Market on the date of grant. One-third of
the options become exercisable on each of the first three anniversaries of the
date of grant. Mr. Margalit also uses a company car and is entitled to 25 days
of paid vacation per year, as well as other benefits commonly paid by companies
in Israel.

Dany
Margalit.Dany Margalit served as our executive vice
president, technologies, until April 2006. According to the agreed terms of
engagement with Mr. Margalit, Mr. Margalit continued to receive his monthly
salary and retain the company car used by him until the termination of his employment
relationship with our company (i.e.until
September 30, 2006). Mr. Margalits base salary in 2006 was $115,000. In
December 2003, we granted to Mr. Margalit options to purchase 65,000 of our
ordinary shares at an exercise price per share of $8.52 representing the last
reported sale price of our ordinary shares on The Nasdaq Global Market on the
date of grant. One quarter of the options become exercisable on each of the
first four anniversaries of the date of grant.
As of April 2006, Mr. Margalit began providing our company with advisory
services. In consideration for these services, we pay him a monthly
compensation of $6,000 as of October 1, 2006. In addition, we reimburse Mr.
Margalit, currently a non-employee director of our company, in the same amounts
payable to our outside directors.

C.               Board
Practices

Board of directors
and executive officers

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

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

Outside and
independent directors

Under
the Companies Law, companies incorporated under Israeli Law, whose shares have
been offered to the public in or outside of Israel, are required to appoint at
least two outside directors. The Companies Law provides that a person may not
be appointed as an outside director if such person or persons relative,
partner, employer or any entity under such persons control, has, as of the
date of such persons appointment as an outside director, or had, during the
two years preceding that date, any affiliation with the company or any entity
controlling, controlled by or under common control with the company. The term
affiliation includes:

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

38

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

| |     |                                                                                                                                                                          
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | the shares
  voting in favor of such resolution include at least one-third of the shares
  voted by shareholders who are not controlling shareholders; or                
| |     |                                                                                                                                                                          
| | (2) | the total
  number of shares voted against the resolution by shareholders who are not
  controlling shareholders does not exceed one percent of our outstanding
  shares.

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

The
initial term of an outside director is three years and may be extended for an
additional three year term. Under a recent amendment to the Israeli Companies
Regulations (Alleviation for Public Companies Whose Shares are Listed on a
Stock Exchange Outside of Israel) 2000, dual listed companies, like us, may
appoint an outside director for additional three-year terms, above the maximum
six-year term permitted under the Companies Law, if the audit committee and the
board of directors confirm that due to the expertise and special contribution
of the outside director to the work of the board and its committees, his
re-appointment is in the best interests of the company. Dr. Orna Berry was
appointed as an outside director on December 31, 2001 for an initial three-year
term and was reappointed for a second three-year term, ending December 31,
2007. Dr. Menahem Gutterman was appointed as an outside director in 2000 for an
initial three-year term and was reappointed in December 2003 for a second
three-year term. At the general meeting held in December 2006, following a
determination by the audit committee and the Board that he should be
reappointed for a third term due to his experience and special contributions,
Dr. Gutterman was appointed for an additional three-year term, ending on
December 31, 2009.

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

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

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

Qualifications of
other directors

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

39

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Audit committee

The
board of directors of an Israeli public company must appoint an audit committee
comprised of at least three directors, which must include all of the companys
outside directors. The chairman of the board, any controlling shareholder, any
relative of a controlling shareholder or any director which is employed or
provides services to the company on a regular basis (other than as a board
member) may not serve on the audit committee. Under The Nasdaq Global Market
listing requirements, we are required to have an audit committee consisting of
independent directors who are financially literate and one of whom has
accounting or related financial management expertise.

Currently,
the members of our audit committee are Mr. Assia, Dr. Gutterman and Dr. Berry.
The rules of the Securities and Exchange Commission require us to disclose whether
one or more members of our audit committee is a financial expert. We believe
that Mr. Assia qualifies as a financial expert under the SEC rules.

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

Internal
auditor

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

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

Compensation and
nominating committees

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

D.               Employees

As
of December 31, 2006, we and our subsidiaries had 440 employees of whom 268
were based in Israel, 104 in Europe, 55 in the United States, 11 in Japan and
Asia, one in Brazil and one in India.

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

|                                |  |                    |     |      |  |      |  |  |     | 
|------------------------------- |  | ------------------ | --- | ---- |  | ---- |  |  | --- | 
|                                |  | As of December 31, |    
|Activity                        |  | 2004               |     | 2005 |  | 2006 | 
|                                |  |                    |     |      |  |      | 
|Manufacturing                   |  |                    | 61  |      |  | 58   |  |  | 70  | 
|Research and
  development      |  |                    | 153 |      |  | 163  |  |  | 174 | 
|Marketing
  and sales           |  |                    | 86  |      |  | 92   |  |  | 111 | 
|Administration
  and management |  |                    | 76  |      |  | 87   |  |  | 85  | 
|                                |  |                    |     |      |  |      |  |  |     | 
|Total                           |  |                    | 376 |      |  | 400  |  |  | 440 | 

40

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

E.               Share
Ownership

All
of the persons listed above, under the caption Directors and Senior
Management who are employed by us, own shares and/or options to purchase
ordinary shares. Except as set forth below, none of the named directors or
employees owns shares and/or options amounting to 1% or more of our outstanding
ordinary shares. As of June 20, 2007, Jacob (Yanki) Margalit beneficially owned
1,758,549 ordinary shares, representing 12.32% of our outstanding share
capital, and Dany Margalit owned 859,195 ordinary shares, representing 6.02% of
our outstanding share capital. Information regarding our share option plans
presented in Note 14(e) to our consolidated financial statements is
incorporated herein by reference.

In
January 2007, our board of directors approved an amendment to our Worldwide
2003 Share Option Plan pursuant to which we are authorized to grant to
employees restricted share units (in addition to options to purchase shares initially
authorized under the plan) in accordance with the terms of the plan. As of June
20, 2007 we have not yet granted to our employees restricted share units under
the plan.

|        |                                                  
|------- | -------------------------------------------------
|Item 7. | MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS

A.               Major Shareholders

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

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

We
have determined beneficial ownership in accordance with the rules of the
Securities and Exchange Commission. Unless indicated otherwise, to our
knowledge, the persons and entities named in the table below have sole voting
and sole dispositive power with respect to all shares beneficially owned,
subject to community property laws where applicable. Ordinary shares and
options that are currently exercisable or exercisable within 60 days after the
date of this report are deemed outstanding and beneficially owned by the person
holding the options for the purpose of computing the percentage ownership of
that person, but are not treated as outstanding for the purpose of computing
the percentage ownership of any other person. Unless indicated below, the
address for each listed shareholder is c/o Aladdin Knowledge Systems Ltd., 35
Efal Street, Kiryat Arye, Petach Tikva 49511, Israel.

The
percentage of shares beneficially owned is based on 14,272,252 ordinary shares
outstanding as of June 20, 2007, and excludes 464,973 shares which were
purchased under our buy back program and are held by Aladdin. Pursuant to Israeli
law, the shares held by Aladdin do not confer upon Aladdin any voting rights
(although such

41

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shares entitle
their holder to participation rights upon distribution). For more information
about our buy back program, see below.

|                                                                  |  |                                         |  |                                   |       |   | 
|----------------------------------------------------------------- |  | --------------------------------------- |  | --------------------------------- | ----- | - | 
|Name                                                              |  | Number of
  Shares
  Beneficially Owned |  | Percent of
  Outstanding
  Shares |      
|                                                                  |  |                                         |  |                                   |      
|                                                                 
|Juniper Trading Services,
  Inc.(1)                               |  | 2,104,700                               |  |                                   | 14.75 | % | 
|Jacob (Yanki) Margalit (2)                                        |  | 1,858,549                               |  |                                   | 13.02 | % | 
|Galleon Advisors, L.L.C. (3)                                      |  | 1,641,740                               |  |                                   | 11.50 | % | 
|BlackRock, Inc. (4)                                               |  | 1,400,072                               |  |                                   | 9.81  | % | 
|FMR Corp. (5)                                                     |  | 1,273,200                               |  |                                   | 8.92  | % | 
|Tracer Capital Management
  L.P. (6)                              |  | 1,120,434                               |  |                                   | 7.85  | % | 
|Diker Management, L.L.C. (7)                                      |  | 977,265                                 |  |                                   | 6.85  | % | 
|Dany Margalit (8)                                                 |  | 924,195                                 |  |                                   | 6.48  | % | 
|All
  directors and executive officers as a group (8 persons) (9) |  | 2,926,094                               |  |                                   | 20.50 | % | 




(1) Based on a Schedule 13D
filed on September 29, 2000. The address of Juniper Trading Services, Inc. is
Compass Point Building, 9 Bermudiana Road, Bermuda.


(2) Consists of 1,758,549
ordinary shares and options to purchase 100,000 ordinary shares.

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

(4) Based on a Schedule 13G
filed on February 14, 2007. The beneficial ownership indicated above represents
the aggregate beneficial ownership of the following subsidiaries of BlackRock,
Inc.: BlackRock Advisors LLC, BlackRock Investment Management UK Ltd.,
BlackRock Capital Management, Inc., BlackRock Investment Management LLC,
BlackRock (Channel Islands) Ltd., BlackRock Japan Co. Ltd. and State Street
Research & Management Co. BlackRock, Inc. is located at 40 East 52nd
Street, New York, NY 10022.

(5) Based on a Schedule 13G
filed on February 14, 2007. The beneficial ownership above represents the
aggregate beneficial ownership of FMR Corp. and Fidelity International Limited,
parent companies of various investment advisors that manage institutional accounts
and open-end investment companies. FMR Corp. is located at 82 Devonshire
Street, Boston, Massachusetts, and Fidelity International is located at P.O.
Box 670, Hamilton, HMCX, Bermuda.

(6) Based on a Schedule 13G
filed on February 6, 2007. The beneficial ownership indicated above
represents the aggregate beneficial ownership of Tracer Capital Management
L.P., Tracer Capital Partners, L.P., Tracer Capital Partners QP, L.P. and
Tracer Capital Offshore Fund Ltd. c/o Goldman Sachs (Cayman) Trust Limited.
Tracer Capital Management L.P. is located at 540 Madison Avenue, 33rd
Floor, New York, New York 10022, and is controlled by Riley McCormack and Matt
Hastings.

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

(8) Consists of 859,195
ordinary shares and options to purchase 65,000 ordinary shares.

(9) Consists of 2,617,744
ordinary shares and options to purchase 308,350 ordinary shares.

To
our knowledge, the only significant change in the percentage of ownership held
by any major beneficial shareholders during the past three years has been the
change in the ownership by FMR Corp. In the past several months, FMR Corp has
decreased its percentage of ownership from 14.7% to its current percentage
ownership of 8.7%.

The
voting rights of our major shareholders do not differ from the voting rights of
other holders of our ordinary shares, except for the voting rights of Aladdin
with respect to the shares held by it as described below.

42

---



As
of May 31, 2007, there were a total of 53 holders of record of our outstanding
ordinary shares, of which 32 were registered with addresses in the United
States. Such United States holders were, as of such date, the holders of record
of approximately 82% of our issued and outstanding ordinary shares

B.               Related Party Transactions

Directors Fees

We
pay directors fees in respect of service by our non-employee directors
(including outside directors). For more information, see Item 6.B. Directors,
Senior Management and Employees  Compensation.

Agreements with
Directors and Officers

Employment
agreements

We
maintain written employment agreements with all of our officers. In addition,
we entered into a written agreement with Dany Margalit, a director and advisor
of our company. For more information regarding the compensation of our
officers, see Item 6.B. Directors, Senior Management and Employees 
Compensation.

Indemnification and
insurance

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

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

For more
information about indemnification and insurance of our directors and officers,
see Item 10.B. Memorandum and Articles of Association - Exculpation, insurance
and indemnification of directors and officers.

C.               Interests of Experts and Counsel

Not
applicable.

|        |                      
|------- | ---------------------
|Item 8. | FINANCIAL INFORMATION

A.               Consolidated Statements and Other
Financial Information

The
financial statements required by this item are found at the end of this annual
report, beginning on page F-1.

Legal Proceedings

We
are not involved in any proceedings in which any of our directors, members of
our senior management or any of our affiliates is either a party adverse to us
or to our subsidiaries or has a material interest adverse to us or to our
subsidiaries. We are also not involved in any material legal proceedings,
except as described below.

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

43

---



Feitian infringe those patents, and agreed to
cease to import, distribute, sell, or offer to sell in or into the United
States any products that infringe these patents. Feitian and several other
defendants moved to dismiss the case on the basis that the court did not have
jurisdiction over them. The court granted the motion as to certain defendants
and dismissed the case against them without prejudice. The court denied the motion
as to Feitian and another defendant, RS-Computer. The court allowed us to
proceed with the discovery to support our claim that the court has jurisdiction
over Feitian and RS-Computer. Upon the completion of the discovery, we filed a
supplemental brief with the court concerning the jurisdictional issues. We
intend to vigorously pursue our claims whether we remain in the federal court
in Delaware or file a lawsuit in another court in the United States. At this
stage, we cannot predict the outcome of the proceedings.

Dividend policy

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

B.               Significant Changes

Except
as otherwise disclosed in this annual report, there has been no material change
in our financial position since December 31, 2006.

|        |                      
|------- | ---------------------
|Item 9. | THE OFFER AND LISTING

A.               Offer and Listing Details

On
June 20, 2007, the last reported sale price of our ordinary shares on The
Nasdaq Global Market was $20.58 per share. The table below sets forth the high and low closing
sales prices of our ordinary shares, as reported by The Nasdaq Global Market
during the periods indicated:

|                                    |  |      |       |     |   |       | 
|----------------------------------- |  | ---- | ----- | --- | - | ----- | 
|                                    |  | High |       | Low |  
|Annual                              |  |      |       |     |   |       | 
|2006                                |  | $    | 23.57 |     | $ | 13.72 | 
|2005                                |  |      | 25.40 |     |   | 15.95 | 
|2004                                |  |      | 32.12 |     |   | 8.73  | 
|2003                                |  |      | 10.10 |     |   | 2.25  | 
|2002                                |  |      | 3.86  |     |   | 0.85  | 
|                                    |  |      |       |     |   |       | 
|Quarterly                           |  |      |       |     |   |       | 
|First
  Quarter 2007                |  | $    | 19.53 |     | $ | 16.83 | 
|Fourth
  Quarter 2006               |  |      | 19.49 |     |   | 16.52 | 
|Third
  Quarter 2006                |  |      | 20.35 |     |   | 13.72 | 
|Second
  Quarter 2006               |  |      | 23.57 |     |   | 19.15 | 
|First
  Quarter 2006                |  |      | 22.49 |     |   | 16.81 | 
|Fourth
  Quarter 2005               |  |      | 21.29 |     |   | 15.95 | 
|Third
  Quarter 2005                |  |      | 22.21 |     |   | 18.45 | 
|Second
  Quarter 2005               |  |      | 24.36 |     |   | 19.91 | 
|First
  Quarter 2005                |  |      | 25.40 |     |   | 19.60 | 
|                                    |  |      |       |     |   |       | 
|Most Recent Six Months              |  |      |       |     |   |       | 
|June 2007
  (through June 20, 2007) |  | $    | 22.78 |     | $ | 20.21 | 
|May 2007                            |  |      | 22.26 |     |   | 20.52 | 
|April 2007                          |  |      | 21.47 |     |   | 16.89 | 

44

---



|                |  |      |       |     |  |       | 
|--------------- |  | ---- | ----- | --- |  | ----- | 
|                |  | High |       | Low | 
|Annual          |  |      |       |     |  |       | 
|March 2007      |  |      | 17.65 |     |  | 16.84 | 
|February
  2007 |  |      | 17.98 |     |  | 16.83 | 
|January 2007    |  |      | 19.53 |     |  | 17.04 | 
|December
  2006 |  |      | 18.48 |     |  | 17.16 | 

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

|                                    |  |      |        |     |     |       | 
|----------------------------------- |  | ---- | ------ | --- | --- | ----- | 
|                                    |  | High |        | Low |    
|Annual                              |  |      |        |     |     |       | 
|2006                                |  | NIS  | 108.30 |     |     | 60.83 | 
|2005                                |  |      | 112.40 |     |     | 73.88 | 
|2004 (since
  July, 28, 2004)       |  |      | 137.80 |     |     | 69.47 | 
|                                    |  |      |        |     |     |       | 
|Quarterly                           |  |      |        |     |     |       | 
|First
  Quarter 2007                |  | NIS  | 82.15  |     | NIS | 70.60 | 
|Fourth
  Quarter 2006               |  |      | 80.37  |     |     | 70.23 | 
|Third
  Quarter 2006                |  |      | 89.90  |     |     | 60.83 | 
|Second
  Quarter 2006               |  |      | 108.30 |     |     | 86.22 | 
|First
  Quarter 2006                |  |      | 103.90 |     |     | 77.51 | 
|Fourth
  Quarter 2005               |  |      | 95.63  |     |     | 73.88 | 
|Third
  Quarter 2005                |  |      | 100.70 |     |     | 83.55 | 
|Second
  Quarter 2005               |  |      | 105.90 |     |     | 88.24 | 
|First
  Quarter 2005                |  |      | 112.40 |     |     | 85.66 | 
|                                    |  |      |        |     |     |       | 
|Most Recent Six Months              |  |      |        |     |     |       | 
|June 2007
  (through June 20, 2007) |  | NIS  | 91.78  |     | NIS | 83.82 | 
|May 2007                            |  |      | 88.98  |     |     | 81.00 | 
|April 2007                          |  |      | 88.14  |     |     | 70.78 | 
|March 2007                          |  |      | 75.94  |     |     | 70.60 | 
|February
  2007                     |  |      | 75.11  |     |     | 72.15 | 
|January 2007                        |  |      | 82.15  |     |     | 72.85 | 
|December
  2006                     |  |      | 79.93  |     |     | 72.45 | 

As
of June 20, 2007, the exchange rate of the NIS to the U.S. dollar was
$1=NIS 4.187

B.               Plan of Distribution

Not
applicable.

C.               Markets

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

Pursuant
to NASDAQ Marketplace Rule 4350(a)(1), we received an exemption from
Marketplace Rule 4350(i)(1), which requires a company to seek shareholder
approval prior to the issuance of securities. We follow Israeli law and
practice. For issuances of securities, we obtain the approval of our board of
directors and in certain circumstances, we also obtain the approval of our
audit committee or share option compensation committee. Our practices comply
with the Israeli law.

D.               Selling Shareholders

Not
applicable.

45

---



E.               Dilution

Not
applicable.

F.               Expenses of the Issue

Not
applicable.

|         |                       
|-------- | ----------------------
|Item 10. | ADDITIONAL INFORMATION

A.               Share Capital

Not
applicable.

B.               Memorandum and Articles of Association

We
are registered with the Israeli Companies Register under the number
52-004003-1. Our objects are specified in our articles of association and
include engaging in any lawful act or activity for which companies may be
organized under the Companies Law.

Approval
of certain transactions under the Companies Law

The
Companies Law codifies the fiduciary duties that office holders, including
directors and executive officers, owe to a company. An office holders
fiduciary duties consist of a duty of care and a duty of loyalty. The duty of
loyalty includes (i) avoiding any conflict of interest between the office
holders position in the company and his personal affairs; (ii) avoiding any
competition with the company; (iii) avoiding exploiting any business
opportunity of the company in order to receive personal advantage for himself
or others; and (iv) revealing to the company any information or documents
relating to the companys affairs which the office holder has received due to
his position as an office holder. Each person listed in the table in Item 6A
under Directors and Senior Management is an office holder. Under the
Companies Law, arrangements regarding the compensation of directors (whether in
their capacity as directors or in any other position in the company) require
the approval of the audit committee, the board of directors and shareholders.
Arrangements regarding compensation of officers who do not serve as directors,
require the approval of the audit committee and the board of directors.

The
Companies Law requires that an office holder of a company promptly disclose any
personal interest that he or she may have and all related material information
known to him or her, in connection with any existing or proposed transaction or
act by the company. In addition, if the transaction is an extraordinary
transaction as defined under the Companies Law, the office holder must also
disclose any personal interest of the office holders spouse, siblings,
parents, grandparents, descendants, spouses descendants and the spouses of any
of the foregoing. In addition, the office holder must also disclose any
interest of any corporation in which the office holder owns 5% or more of the
share capital, is a director or general manager or in which he or she has the
right to appoint at least one director or the general manager. An
extraordinary transaction is defined as a transaction conducted not in the
ordinary course of business, not on market terms or that is likely to have a
material impact on the companys profitability, assets or liabilities.

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

46

---



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

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

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

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

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

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

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

Our Articles of
Association

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

Holders
of ordinary shares have one vote per share, and are entitled to participate
equally in the payment of dividends and share distributions and, in the event
of our liquidation, in the distribution of assets after satisfaction of
liabilities to creditors. Our articles of association may be amended by a
resolution carried at a general meeting by an ordinary majority (50%) of those
who voted on the matter. The shareholders rights may not be modified in any
other way unless otherwise expressly provided in the terms of issuance of the
shares.

Our
articles of association require that we hold our annual general meeting of
shareholders once every calendar year and in accordance with the timing
requirements set forth under Israeli law, at a time and place determined by the
board of directors. A 21-day prior written notice shall be given to our
shareholders with respect to every shareholders meeting. In some instances
specified in regulations promulgated under the Companies Law, a 35-

47

---



day prior
notice should be given of a shareholders meeting. No business may be commenced
until a quorum of two or more shareholders who hold or represent between or
among them at least 33 1/3% of the Companys issued share capital are present
in person or by proxy. If within a half hour from the time appointed for the
meeting a quorum is not present, the meeting, shall be dissolved, but in any
other case it shall stand adjourned for one week, at the same day, time and
place as specified in the notice or to such later day and at such time and
place as the chairman may determine with the consent of a simple majority. No
further notice of the adjourned meeting is required to be given. If a quorum is
not present at the adjourned meeting within half an hour of the time fixed for
the commencement thereof, subject to the provisions of applicable law, the
persons present shall constitute a quorum. Shareholders may vote in person or
by proxy, and will be required to prove title to their shares as required by
the Companies Law pursuant to procedures established by the board of directors.
Resolutions regarding the following matters must be passed at a general meeting
of shareholders:

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

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

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

Our
board of directors is authorized to declare dividends, subject to the
provisions of the Companies Law. Dividends on our ordinary shares may be paid
only out of profits and other surplus, as defined in the Companies Law, as of
the end date of the most recent financial statements or as accrued over a
period of two years, whichever is higher. Alternatively, if we do not have
sufficient profits or other surplus, then permission to effect a distribution can
be granted by order of an Israeli court. In any event, our board of directors
is authorized to declare dividends, provided there is no reasonable concern
that the dividend will prevent us from satisfying our existing and foreseeable
obligations as they become due. Dividends may be paid in cash or in kind.

Exculpation,
insurance and indemnification of directors and officers

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

Office holders insurance

Our
articles of association provide that the Company may insure an office holder
for any liability imposed on such office holder in connection with an act
performed in the office holders capacity as an office holder of the company,
subject to the provisions of the Companies Law, with respect to each of the
following: (i) violation of the

48

---



duty of care
of the office holder towards the Company or towards another person; (ii) breach
of fiduciary duty towards the company provided that the office holder acted in
good faith and with reasonable grounds to assume that the action in question
was in the best interests of the company; (iii) a financial obligation imposed
on the office holder for the benefit of another person; and (iv) any other
obligation or expense for which it is or shall be permitted to insure and
office holder.

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

Indemnification of office holders

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

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

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

The
foregoing shall not apply under certain circumstances defined in the Companies
Law as described below.

Limitations on exemption, insurance and
indemnification

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

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

These
limitations are included in our articles of association.

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

49

---



Anti-takeover
provisions; mergers and acquisitions under Israeli law

Mergers

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

Tender offers

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

C.               Material Contracts

None.

D.               Exchange Controls

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

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

50

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E.              Taxation

Israeli Taxation

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

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

Tax Consequences Regarding Disposition of Our Ordinary Shares

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

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

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

Israeli
individual shareholders selling our ordinary shares are subject to 20% tax rate
on any real capital gain accrued after January 1, 2003, or 25% tax rate if such
individual shareholder holds more than 10% interest in the company. Israeli
corporate shareholders (which were subject to the provisions of the
Inflationary Adjustments Law, prior to the publishing of amendment no. 147 to
the Income Tax Ordinance, in 2005), selling our ordinary shares are subject to
a 25% tax rate on any real capital gain. Israeli corporate shareholders which
were subject in 2005 to the provisions of the Inflationary Adjustments Law,
selling our ordinary shares are subject to the regular corporate tax rates on
any capital gain.

Taxes Applicable to Dividends

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

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

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

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

U.S. Taxation

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

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

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

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

This
discussion is based on current provisions of the Internal Revenue Code of 1986,
as amended (the Code), current and proposed Treasury Regulations promulgated
under the Code and administrative and judicial interpretations of the Code, all
as currently in effect and all of which are subject to change, possibly with
retroactive effect. This discussion does not address all aspects of U.S.
federal income taxation that may be relevant to any particular U.S. holder
based on the U.S. holders particular circumstances. In particular, this
discussion does not address the U.S. federal income tax consequences to U.S.
holders who are broker-dealers or who own, directly, indirectly or
constructively, 10% or more of our outstanding shares (by vote), real estate
investment trusts, regulated investment companies, grantor trusts, U.S. holders
holding the ordinary shares as part of a hedging, straddle or conversion
transaction, U.S. holders whose functional currency is not the U.S. dollar,
insurance companies, tax-exempt organizations, financial institutions, persons
that receive ordinary shares as compensation for the performance of services,
certain former citizens or long-term residents of the United States and persons
subject to the alternative minimum tax, who may be subject to special rules not
discussed below. Additionally, this discussion

52

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does not
address the possible application of U.S. federal estate or gift taxes or any
aspect of state, local or non-U.S. tax laws.

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

U.S.
Holders of Ordinary Shares

Taxation of distributions on ordinary shares

Subject
to the discussion below under Tax Consequences if we are a passive foreign
investment company, a distribution paid by us with respect to our ordinary
shares, including the amount of any non-US taxes withheld, to a U.S. holder
will be treated as dividend income to the extent that the distribution does not
exceed our current and accumulated earnings and profits, as determined for U.S.
federal income tax purposes. Dividends that are received with respect to
ordinary shares by U.S. holders that are individuals, estates or trusts
generally will be taxed at the rate applicable to long-term capital gains
(currently a maximum rate of 15% for the taxable years beginning on or before
December 31, 2010), provided that such dividends meet the requirements of
qualified dividend income. Dividends that fail to meet such requirements, and
dividends received by corporate U.S. holders, are taxed at ordinary income
rates. No dividend received by a U.S. holder will be a qualified dividend
(1) if the U.S. holder held the ordinary share with respect to which the
dividend was paid for less than 61 days during the 121-day period
beginning on the date that is 60 days before the ex-dividend date with
respect to such dividend, excluding for this purpose, under the rules of Code
section 246(c), any period during which the U.S. holder has an option to sell,
is under a contractual obligation to sell, has made and not closed a short sale
of, is the grantor of a deep-in-the-money or otherwise nonqualified option to
buy, or has otherwise diminished its risk of loss by holding other positions
with respect to, such ordinary share (or substantially identical securities);
or (2) to the extent that the U.S. holder is under an obligation (pursuant to a
short sale or otherwise) to make related payments with respect to positions in
property substantially similar or related to the ordinary share with respect to
which the dividend is paid. If we were to be a passive foreign investment
company (as such term is defined in the Code) for any year, dividends paid on
our ordinary shares in such year or in the following year would not be
qualified dividends. In addition, a non-corporate U.S. holder will be able to
take a qualified dividend into account in determining its deductible investment
interest (which is generally limited to its net investment income) only if it
elects to do so; in such case the dividend will be taxed at ordinary income
rates.

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

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

Subject
to the limitations set forth in the Code and the Treasury Regulations
thereunder, U.S. holders may elect to claim as a foreign tax credit against
their U.S. federal income tax liability the non-U.S. income tax withheld from
dividends received in respect of the ordinary shares. The limitations on
claiming a foreign tax credit include, among others, computation rules under
which foreign tax credits allowable with respect to specific classes of income
cannot exceed the U.S. federal income taxes otherwise payable with respect to
each such class of income. In this regard, dividends paid by us will be foreign
source passive income for U.S. foreign tax credit purposes or, in the case of
certain U.S. holders, financial services income (for tax years beginning
after December 31, 2006, as general category income). U.S. holders that
do not elect to claim a foreign tax credit may instead claim a deduction for
the non-U.S. income tax withheld if they itemize deductions. The rules relating
to foreign tax credits are complex, and you should consult your tax advisor to
determine whether and to what extent you would be entitled to this credit. A
U.S. holder will be denied a foreign tax credit for non-U.S. income taxes
withheld from a dividend

53

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received on
the ordinary shares (i) if the U.S. holder has not held the ordinary
shares for at least 16 days of the 31-day period beginning on the date
which is 15 days before the ex-dividend date with respect to such dividend
or (ii) to the extent the U.S. holder is under an obligation to make
related payments with respect to positions in substantially similar or related
property. Any days during which a U.S. holder has substantially diminished its
risk of loss on the ordinary shares are not counted toward meeting the required
16-day holding period. Distributions of current or accumulated earnings and
profits will be foreign source passive income for U.S. foreign tax credit
purposes.

Taxation of the disposition of ordinary
shares

Subject
to the discussion below under Tax Consequences if we are a passive foreign
investment company, upon the sale, exchange or other disposition of our
ordinary shares, a U.S. holder will recognize capital gain or loss in an amount
equal to the difference between the amount realized on the disposition and the
U.S. holders tax basis in the ordinary shares. The gain or loss recognized on
the disposition of the ordinary shares will be long-term capital gain or loss
if the U.S. holder held the ordinary shares for more than one year at the time
of the disposition (long-term capital gains are currently taxable at a maximum
rate of 15% for taxable years beginning on or before December 31, 2010).
Capital gain from the sale, exchange or other disposition of ordinary shares
held for one year or less is short-term capital gain. Gain or loss recognized
by a U.S. holder on a sale, exchange or other disposition of ordinary shares
will be generally treated as U.S. source income or loss for U.S. foreign tax
credit purposes.

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

Tax consequences if we are a passive foreign
investment company

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

We
believe that we were not a PFIC for our 2006 taxable year. Our status in the
current and future taxable years will depend on our assets and income in those
years. We have no reason to believe that our assets or income will change in a
manner that would cause us to be classified as a PFIC. However, since the
determination of whether we are a PFIC is based upon such factual matters as
the valuation of our assets (which may depend upon our market capitalization,
which is subject to fluctuation) and, in certain cases, the assets of companies
held by us, there can be no assurance that we will not become a PFIC. If we
were a PFIC, and you are a U.S. holder, you generally would be subject to
imputed interest charges and other disadvantageous tax treatment with respect
to any gain from the sale or exchange of, and certain distributions with
respect to, your ordinary shares (including the denial of the taxation of such
distributions and gains at the lower rates applicable to long-term capital
gains as discussed above under Taxation of distributions on ordinary shares
and Taxation of the disposition of ordinary shares).

If
we were a PFIC, you could make certain elections that may alleviate certain tax
consequences referred to above, and one of these elections may be made
retroactively if certain conditions are satisfied. It is expected that the

54

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conditions
necessary for making certain of such elections will apply in the case of our
ordinary shares. We will notify U.S. holders in the event we conclude that we
will be treated as a PFIC for any taxable year.

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

Information reporting and backup withholding

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

Non-U.S.
Holders of Ordinary Shares

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

Non-U.S.
holders are generally not subject to information reporting or backup
withholding with respect to the payment of dividends on, or proceeds from the
disposition of, ordinary shares, provided that the non-U.S. holder provides its
taxpayer identification number, certifies to its foreign status or otherwise
establishes an exemption.

F.               Dividends and Paying Agents

Not
applicable.

G.               Statements by Experts

Not
applicable.

H.               Documents on Display

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

You
may review a copy of our filings with the SEC, including any exhibits and
schedules, at the SECs public reference facilities in 100 F Street, N.E.,
Washington, D.C. 20549 and at the regional offices of the SEC located at the
Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. You may also obtain copies of such materials from the Public
Reference Section of the SEC, 100 F Street, N.E., Washington,

55

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D.C. 20549, at
prescribed rates. You may call the SEC at 1-800-SEC-0330 for further
information on the public reference rooms. In addition, such information
concerning our company can be inspected and copied at the offices of the
National Association of Securities Dealers, Inc., 9513 Key West Avenue,
Rockville, Maryland 20850 and at the offices of the Israel Securities Authority
at 22 Kanfei Nesharim St., Jerusalem, Israel. As a foreign private issuer, all
documents which were filed after November 4, 2002 on the SECs EDGAR system
will be available for retrieval on the SECs website at www.sec.gov. You may
read and copy any reports, statements or other information that we file with
the SEC at the SEC facilities listed above. These SEC filings are also
available to the public from commercial document retrieval services. We also
generally make available on our own web site all our quarterly and year-end
financial statements as well as other information.

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

I.               Subsidiary Information

Not
applicable.

|         |                                                           
|-------- | ----------------------------------------------------------
|Item 11. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

Foreign exchange
risk

Although
we report our consolidated financial statements in U.S. dollars, in 2006 a
portion of our revenues and expenses was denominated, in other currencies. We
derived approximately 50% of revenues in U.S. dollars, 33% in euros, 10% in
Japanese Yen and 7% in British pounds. In 2006, 75% of our expenses was
denominated in U.S. dollars, 18% in euros, 4% in Japanese Yen and 3% in British
pounds.

Exchange
differences upon translation from the functional currency of our German
subsidiary, which is the euro, to U.S. dollars are accumulated as a separate
component of accumulated other comprehensive loss under shareholders equity.
As of December 31, 2006, accumulated other comprehensive loss decreased
by$441,000 compared to December 31, 2005. As of December 31, 2005,
accumulated other comprehensive loss increased by $492,000 compared to
December 31, 2004. Exchange differences upon translation from the
functional currency from our other selling and marketing subsidiaries (other
than our U.S. subsidiary) to U.S. dollars are reflected in our income statement
under financial income net.

We
have entered into foreign currency forward contracts and forward exchange
options generally of less than one year duration to hedge a portion of our
foreign currency risk on sales transactions and on non-U.S. dollar monetary
items. The objective of these transactions is to hedge cash flow in U.S.
dollars and non-U.S. dollar monetary items against fluctuations in the exchange
rates of the euro, British pound and the Japanese Yen. As of December 31,
2006, we held one euro forward contract with a nominal amount of 530,000 euros,
one British pound forward contract with a nominal amount of 430,000 British
pounds, one Japanese Yen forward contract with nominal amount of 160 million
Japanese Yen and one New Israeli Shekel forward contract with a nominal amount
of NIS 6 million.

Equity Investments

We
held equity investments in two companies whose securities are traded on the Tel
Aviv Stock Exchange, Tamir Fishman Venture Capital II Ltd. and Comsec
Information Security Ltd. In 2006, we sold these investments for an aggregate
consideration of $1.4 million.

As
of December 31, 2006, we had invested approximately $8.1 million in two
related private investment funds managed by Tamir Fishman
Ventures Management II Ltd. Each of these funds invests primarily in
securities of privately-held technology companies in Israel.

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In
    2002, we recognized an impairment charge of $1.0 million related to these
    investments and we may recognize additional impairment charges in the future.
    We have a commitment to invest an additional $400,000 in these entities.
    In April 2006 and in April 2005, as a result of exit transactions for portfolio
    companies managed by Tamir Fishman Ventures Management II Ltd., we received
    cash proceeds of $1.7 million and $910,000, respectively. The proceeds from
    these distributions received in 2005 and 2006 were recorded as a return of
    investment.

Interest rate risk

Our
investments consist primarily of cash and cash equivalents, consisting of
short-term bank deposits with maturities of up to three months. In November
2004 and July 2005, we invested in U.S. government bonds with maturities of up
to three and two years, respectively. The bonds mature in 2007.

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

|         |                                                        
|-------- | -------------------------------------------------------
|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 15T. | CONTROLS AND PROCEDURES

(a)
Disclosure
Controls and Procedures.Our chief executive officer and chief
financial officer, after evaluating the effectiveness of our disclosure
controls and procedures (as defined in Rule 13a-15(e) of the Securities
Exchange Act of 1934, as amended) as of December 31, 2006, have concluded
that, as of such date, our disclosure controls and procedures were effective to
ensure that information required to be disclosed by us in reports that we file
or submit under the Exchange Act is accumulated and communicated to our
management, including our chief executive officer and chief financial officer,
to allow timely decisions regarding required disclosure and is recorded, processed,
summarized and reported within the periods specified by the SECs rules and
forms.

(b)
Management Annual Report on Internal Control
over Financial Reporting. Our board of directors and audit committee
are responsible for establishing and maintaining adequate internal control over
financial reporting. Our internal control system was designed to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation and fair presentation of our consolidated financial statements.

Our
chief executive officer and chief financial officer assessed the effectiveness
of our internal control over financial reporting as of December 31, 2006. In
making this assessment, they used the criteria established in Internal Control
 Integrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO). Based on this assessment, our chief executive
officer and chief financial officer have concluded that, as of December 31,
2006, our internal control over financial reporting is effective based on those
criteria.

Notwithstanding
the foregoing, all internal control systems no matter how well designed have
inherent limitations. Therefore, even those systems determined to be effective
may not prevent or detect misstatements and can provide only reasonable
assurance with respect to financial statement preparation and presentation.
Also,

57

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projections of any
evaluation of effectiveness to future periods are subject to the risk that controls
may become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.

(c)
Firm Report of the Registered Public Accounting Firm. This annual report
does not include an attestation report of our registered public accounting
firm assessing our internal control over financial reporting. Our managements
report was not subject to attestation by our registered public accounting firm
pursuant to temporary rules of the SEC that permit us to provide only the
managements report in this annual report.

(d)
Changes
in Internal Control over Financial Reporting.Since the date of the
evaluation described above, there have been no significant changes in our
internal controls over financial reporting or in other factors that have
materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.

|          |                                 
|--------- | --------------------------------
|Item 16A. | AUDIT COMMITTEE FINANCIAL EXPERT

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

|          |               
|--------- | --------------
|Item 16B. | CODE OF ETHICS

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

|          |                                       
|--------- | --------------------------------------
|Item 16C. | PRINCIPAL ACCOUNTANT FEES AND SERVICES

The
following table presents fees for professional audit services rendered by Kost,
Forer, Gabbay & Kaisierer, a member of Ernst & Young Global, for the
audit of our consolidated annual financial statements for the years ended
December 31, 2006 and 2005, and fees billed for other services rendered by
Ernst & Young LLP.

|                        |  |      |         |      |   |         | 
|----------------------- |  | ---- | ------- | ---- | - | ------- | 
|                        |  | 2006 |         | 2005 |  
|                        |  |      |         |      |  
|Audit
  Fees(1)         |  | $    | 226,649 |      | $ | 189,440 | 
|Audit-Related
  Fees(2) |  | $    | 51,591  |      | $ | 45,774  | 
|Tax Services
  Fees(3)  |  | $    | 202,290 |      | $ | 164,614 | 
|Other
  Fees(4)         |  | $    | 8,715   |      | $ | 285,067 | 
|                        |  |      |         |      |   |         | 
|Total                   |  | $    | 489,245 |      | $ | 684,895 | 

|    |                                                                                                                                                                                                                                                                                                                                                                    
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|    |                                                                                                                                                                                                                                                                                                                                                                    
|(1) | Audit fees
  consist of fees for professional services rendered for the audit of our
  consolidated financial statements and services normally provided by the
  independent auditor in connection with statutory and regulatory filings or
  engagements.                                                                                                         
|    |                                                                                                                                                                                                                                                                                                                                                                    
|(2) | Audit-related
  fees are fees principally for services that traditionally are performed by
  the independent auditor, including: review of financial statements included
  in our quarterly reports, accounting consultation and consultation concerning
  financial accounting and reporting standards.                                                           
|    |                                                                                                                                                                                                                                                                                                                                                                    
|(3) | Tax services
  fees consist of compliance fees for the preparation of original and amended
  tax returns, claims for refunds and tax payment-planning services for tax compliance,
  tax planning and tax advice. Tax services fees also include fees relating to
  other tax advices, tax consulting and planning other than for tax compliance
  and preparation.
|    |                                                                                                                                                                                                                                                                                                                                                                    
|(4) | Other fees
  consist of fees relating to the secondary offering and implementation of the
  SOX regulations.                                                                                                                                                                                                                                                       

Our
audit committee has adopted a policy for pre-approval of audit and non-audit
services. Under the policy, independent auditor proposed services either may
    be pre-approved without consideration of specific case-by-case services by
    the audit committee, referred to as a general pre-approval, or they may require
    the specific pre-approval of the audit committee, referred to as a specific pre-approval.
    The audit committee employs



58

---



a combination of these two approaches. Unless a type of
service has received general pre-approval, it will require specific
pre-approval by the audit committee if it is to be provided by the independent
auditor. The term of any general pre-approval is 12 months from the date of pre-approval,
unless the audit committee considers a different period and states otherwise.
The audit committee reviews annually and pre-approves the services that may be
provided by the independent auditor without obtaining specific pre-approval
from the audit committee. The audit committee adds to or subtracts from the
list of general pre-approved services from time to time, based on subsequent
determinations.

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

|          |                                                          
|--------- | ---------------------------------------------------------
|Item 16D. | EXEMPTIONS FOR THE LISTING STANDARDS FOR AUDIT COMMITTEES

Not
applicable.

|          |                                                                      
|--------- | ---------------------------------------------------------------------
|Item 16E. | PURCHASE OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS

Not
applicable.

PART III.

|         |                     
|-------- | --------------------
|Item 17. | FINANCIAL STATEMENTS

Not
applicable

|         |                     
|-------- | --------------------
|Item 18. | FINANCIAL STATEMENTS

See
our consolidated financial statements, following the signature page and
certifications below.

|         |         
|-------- | --------
|Item 19. | EXHIBITS

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

|     |                                                                                                                                     
|---- | ------------------------------------------------------------------------------------------------------------------------------------
|1.1  | Articles of
  Association, as amended, dated February 6, 2005. (1)                                                                  
|     |                                                                                                                                     
|1.3  | Memorandum
  of Association of the registrant. (2)(3)                                                                               
|     |                                                                                                                                     
|4.1  | Form of
  Indemnification Agreement between the registrant and each of the members of
  its board of directors and its officers. (4)
|     |                                                                                                                                     
|4.2  | Convertible
  Loan Agreement dated as of April 29, 2004, by and between C-Signature Ltd.
  and the registrant. (4) (5)              
|     |                                                                                                                                     
|8    | List of
  subsidiaries.*                                                                                                            
|     |                                                                                                                                     
|11.  | Code of
  Ethics. (4)                                                                                                               
|     |                                                                                                                                     
|12.1 | Certification
  by Chief Executive Officer pursuant to section 302 of the Sarbanes-Oxley Act
  of 2002.*                            
|     |                                                                                                                                     
|12.2 | Certification
  by Chief Financial Officer pursuant to section 302 of the Sarbanes-Oxley Act
  of 2002.*                            

59

---



|     |                                                                                                         
|---- | --------------------------------------------------------------------------------------------------------
|13.1 | Certification
  by Chief Executive Officer pursuant to section 906 of the Sarbanes-Oxley Act
  of 2002.*
|     |                                                                                                         
|13.2 | Certification
  by Chief Financial Officer pursuant to section 906 of the Sarbanes-Oxley Act
  of 2002.*
|     |                                                                                                         
|15.1 | Consent
  letter from Kost, Forer, Gabbay & Kasierer.*                                                  
|     |                                                                                                         
|15.2 | Consent
  letter from Blick Rothenberg.*                                                                

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

60

---



SIGNATURES

Pursuant
to the requirements of Section 12 of the Securities Exchange Act of 1934, the
registrant certifies that it meets all the requirements for filing on Form 20-F
and has duly caused and authorized the undersigned to sign this Annual Report
on its behalf in the City of Petach Tikva, State of Israel, on this 2 day of
July 2007.

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

---



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                                                         |  |     
|---------------------------------------------------------------------------------------- |  | ----
|                                                                                         |  | Page
|                                                                                         |  |     
|Report of
  Independent Public Accounting Firm                                           |  | F-2 
|Consolidated
  Balance Sheets as of December 31, 2005 and 2006                           |  | F-3 
|Consolidated
  Statements of Income for the years ended December 31, 2004, 2005 and 2006 |  | F-5 
|Statements
  of Changes in Shareholders Equity as of December 31, 2004, 2005 and 2006   |  | F-6 
|Consolidated
  Statements of Cash Flows as of December 31, 2004, 2005 and 2006           |  | F-7 
|Notes to
  Consolidated Financial Statements                                             |  | F-9 

---



EXHIBIT INDEX

|     |                                                                                                                                     
|---- | ------------------------------------------------------------------------------------------------------------------------------------
|1.1  | Articles of
  Association, as amended, dated February 6, 2005. (1)                                                                  
|     |                                                                                                                                     
|1.3  | Memorandum
  of Association of the registrant. (2)(3)                                                                               
|     |                                                                                                                                     
|4.1  | Form of
  Indemnification Agreement between the registrant and each of the members of
  its board of directors and its officers. (4)
|     |                                                                                                                                     
|4.2  | Convertible
  Loan Agreement dated as of April 29, 2004, by and between C-Signature Ltd.
  and the registrant. (4) (5)              
|     |                                                                                                                                     
|8    | List of
  subsidiaries.*                                                                                                            
|     |                                                                                                                                     
|11.  | Code of
  Ethics. (4)                                                                                                               
|     |                                                                                                                                     
|12.1 | Certification
  by Chief Executive Officer pursuant to section 302 of the Sarbanes-Oxley Act
  of 2002.*                            
|     |                                                                                                                                     
|12.2 | Certification
  by Chief Financial Officer pursuant to section 302 of the Sarbanes-Oxley Act
  of 2002.*                            
|     |                                                                                                                                     
|13.1 | Certification
  by Chief Executive Officer pursuant to section 906 of the Sarbanes-Oxley Act
  of 2002.*                            
|     |                                                                                                                                     
|13.2 | Certification
  by Chief Financial Officer pursuant to section 906 of the Sarbanes-Oxley Act
  of 2002.*                            
|     |                                                                                                                                     
|15.1 | Consent
  letter from Kost, Forer, Gabbay & Kasierer.*                                                                              
|     |                                                                                                                                     
|15.2 | Consent letter
  from Blick Rothenberg.*                                                                                            

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

---



ALADDIN KNOWLEDGE SYSTEMS LTD. AND ITS
SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006

IN U.S. DOLLARS

INDEX

|                                                        |  |       
|------------------------------------------------------- |  | ------
|                                                        |  | Page  
|                                                        |  |       
|                                                        |  |       
|Report of Independent Registered Public Accounting Firm |  | 2     
|                                                        |  |       
|Consolidated Balance Sheets                             |  | 3 - 4 
|                                                        |  |       
|Consolidated Statements of Income                       |  | 5     
|                                                        |  |       
|Statements of Changes in Shareholders Equity           |  | 6     
|                                                        |  |       
|Consolidated Statements of Cash Flows                   |  | 7 - 8 
|                                                        |  |       
|Notes to Consolidated Financial Statements              |  | 9 - 43

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

---



(ERNST & YOUNG LOGO)

REPORT OF
INDEPENDENT PUBLIC ACCOUNTING FIRM

To the Board of
Directors and Shareholders of

ALADDIN
KNOWLEDGE SYSTEMS LTD.

We
have audited the accompanying consolidated balance sheets of Aladdin Knowledge
Systems Ltd. (the Company) and its subsidiaries as of December 31, 2005 and
2006, and the related consolidated statements of income, changes in
shareholders equity and cash flows for each of the three years in the period
ended December 31, 2006. These financial statements are the responsibility
of the Companys management. Our responsibility is to express an opinion on
these financial statements, based on our audits. We did not audit the financial
statements of Aladdin Western Europe Ltd., a wholly-owned U.K. subsidiary,
which statements reflect total assets constituting 2% in 2005 and 2006, and
total revenues constituting 16% in 2004, 13% in 2005 and 7% in 2006 of the
related consolidated totals. Those statements were audited by other auditors
whose report has been furnished to us, and our opinion, insofar as it relates
to the data included for Aladdin Western Europe Ltd., is based solely on the
report of the other auditors.

We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. We were not engaged to
perform an audit of the Companys internal control over financial reporting.
Our audits include consideration of internal control over financial reporting
as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the
effectiveness of the Companys internal control over financial reporting.
Accordingly, we express no such opinion. An audit also includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits and the report of
other auditors provide a reasonable basis for our opinion.

In
our opinion, based on our audits and the report of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of the Company and its
subsidiaries as of December 31, 2005 and 2006, and the consolidated results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2006, in conformity with U.S. generally accepted accounting
principles.

As
discussed in Note 2 to the consolidated financial statements, in 2006, the
Company adopted Statement Financial Accounting Standards No. 123(revised 2004),
Share Based Payment.

|                 |                                 
|---------------- | --------------------------------
|Tel-Aviv, Israel | KOST FORER GABBAY & KASIERER    
|July 2, 2007     | A Member of Ernst & Young Global

- 2 -

---



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

|                                                                                               |  |              |         |      |   |         | 
|---------------------------------------------------------------------------------------------- |  | ------------ | ------- | ---- | - | ------- | 
|                                                                                               |  | December 31, |        
|                                                                                               |  |              |        
|                                                                                               |  | 2005         |         | 2006 |  
|                                                                                               |  |              |         |      |  
|ASSETS                                                                                         |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|CURRENT
  ASSETS:                                                                              |  |              |         |      |   |         | 
|Cash and cash equivalents                                                                      |  | $            | 28,426  |      | $ | 39,734  | 
|Marketable securities (Note 3)                                                                 |  |              | 48,815  |      |   | 51,147  | 
|Trade receivables (net of allowance for
  doubtful accounts - $ 377 in 2005 and $ 274 in 2006) |  |              | 13,957  |      |   | 16,427  | 
|Other accounts receivable and prepaid
  expenses (Note 4)                                      |  |              | 3,517   |      |   | 4,253   | 
|Deferred income taxes (Note 12)                                                                |  |              | 1,159   |      |   | 1,526   | 
|Inventories (Note 5)                                                                           |  |              | 6,998   |      |   | 7,299   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|Total
  current assets                                                                         |  |              | 102,872 |      |   | 120,386 | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|LONG-TERM
  INVESTMENTS:                                                                       |  |              |         |      |   |         | 
|Prepaid expenses                                                                               |  |              | 174     |      |   | 202     | 
|Investment in other companies (Note 6)                                                         |  |              | 6,399   |      |   | 5,763   | 
|Severance pay fund                                                                             |  |              | 2,455   |      |   | 2,673   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|Total
  long-term investments                                                                  |  |              | 9,028   |      |   | 8,638   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|PROPERTY AND
  EQUIPMENT, NET (Note 7)                                                         |  |              | 3,081   |      |   | 5,695   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|OTHER ASSETS                                                                                   |  |              |         |      |   |         | 
|Intangible assets, net (Note 8)                                                                |  |              | 1,995   |      |   | 4,045   | 
|Goodwill (Note 9)                                                                              |  |              | 7,685   |      |   | 7,685   | 
|Deferred income taxes (note 12)                                                                |  |              | 1,217   |      |   | 1,595   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|Total
  other assets                                                                           |  |              | 10,897  |      |   | 13,325  | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|Total
  assets                                                                                 |  | $            | 125,878 |      | $ | 148,044 | 
|                                                                                               |  |              |         |      |   |         | 

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 and per share data

|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | ---- | - | ------- | -
|                                                                                                                                                                                                                                |  | December 31, |        
|                                                                                                                                                                                                                                |  |              |        
|                                                                                                                                                                                                                                |  | 2005         |         | 2006 |  
|                                                                                                                                                                                                                                |  |              |         |      |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                                                                                            |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|CURRENT
  LIABILITIES:                                                                                                                                                                                                          |  |              |         |      |   |         |  
|Trade payables                                                                                                                                                                                                                  |  | $            | 4,454   |      | $ | 5,794   |  
|Deferred revenues                                                                                                                                                                                                               |  |              | 5,645   |      |   | 6,173   |  
|Accrued expenses and other accounts payable
  (Note 10)                                                                                                                                                                         |  |              | 7,799   |      |   | 8,618   |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|Total
  current liabilities                                                                                                                                                                                                     |  |              | 17,898  |      |   | 20,585  |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|ACCRUED
  SEVERANCE PAY                                                                                                                                                                                                         |  |              | 3,243   |      |   | 3,441   |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|OTHER LONG TERM LIABILITIES (Note 10)                                                                                                                                                                                           |  |              |        |      |   | 1,369   |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|COMMITMENTS
  AND CONTINGENT LIABILITIES (Note 11)                                                                                                                                                                              |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|SHAREHOLDERS
  EQUITY (Note 13):                                                                                                                                                                                               |  |              |         |      |   |         |  
|Share capital: Ordinary shares of NIS 0.01
  par value - Authorized: 20,000,000 shares at December 31, 2005 and 2006;
  Issued and Outstanding: 14,485,063 and 14,683,488 shares at December 31, 2005
  and 2006, respectively. |  |              | 44      |      |   | 44      |  
|Additional paid-in capital                                                                                                                                                                                                      |  |              | 78,954  |      |   | 82,439  |  
|Deferred stock based compensation                                                                                                                                                                                               |  |              | (15     | )    |   |        |  
|Accumulated other comprehensive loss                                                                                                                                                                                            |  |              | (3,559  | )    |   | (3,178  | )
|Retained earnings                                                                                                                                                                                                               |  |              | 29,313  |      |   | 43,344  |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|Total
  shareholders equity                                                                                                                                                                                                    |  |              | 104,737 |      |   | 122,649 |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|Total
  liabilities and shareholders equity                                                                                                                                                                                    |  | $            | 125,878 |      | $ | 148,044 |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  

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

- 4 -

---



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

|                                                                               |  |                         |            |      |   |            |  |   |            | 
|------------------------------------------------------------------------------ |  | ----------------------- | ---------- | ---- | - | ---------- |  | - | ---------- | 
|                                                                               |  | Year ended December 31, |           
|                                                                               |  |                         |           
|                                                                               |  | 2004                    |            | 2005 |   | 2006       | 
|                                                                               |  |                         |            |      |   |            | 
|Revenues (Note 14):                                                            |  |                         |            |      |   |            |  |   |            | 
|Software security                                                              |  | $                       | 50,650     |      | $ | 56,578     |  | $ | 60,556     | 
|Enterprise security                                                            |  |                         | 18,471     |      |   | 25,195     |  |   | 28,482     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Total revenues                                                                 |  |                         | 69,121     |      |   | 81,773     |  |   | 89,038     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Cost of revenues:                                                              |  |                         |            |      |   |            |  |   |            | 
|Software security                                                              |  |                         | 9,541      |      |   | 9,870      |  |   | 9,292      | 
|Enterprise security                                                            |  |                         | 4,240      |      |   | 7,101      |  |   | 10,721     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Total cost of
  revenues                                                       |  |                         | 13,781     |      |   | 16,971     |  |   | 20,013     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Gross profit                                                                   |  |                         | 55,340     |      |   | 64,802     |  |   | 69,025     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Operating expenses:                                                            |  |                         |            |      |   |            |  |   |            | 
|Research and development                                                       |  |                         | 12,028     |      |   | 12,131     |  |   | 14,336     | 
|Selling and marketing                                                          |  |                         | 24,677     |      |   | 26,952     |  |   | 28,703     | 
|General and administrative                                                     |  |                         | 8,805      |      |   | 11,169     |  |   | 12,780     | 
|Settlement charge (Note 11b)                                                   |  |                         |           |      |   | 2,000      |  |   |           | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Total operating
  expenses                                                     |  |                         | 45,510     |      |   | 52,252     |  |   | 55,819     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Operating income                                                               |  |                         | 9,830      |      |   | 12,550     |  |   | 13,206     | 
|Financial income, net (Note 15a)                                               |  |                         | 53         |      |   | 1,038      |  |   | 3,240      | 
|Other income (expenses), net                                                   |  |                         | (138       | )    |   | 14         |  |   | 284        | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Income before taxes on income                                                  |  |                         | 9,745      |      |   | 13,602     |  |   | 16,730     | 
|Taxes on income (Note 12)                                                      |  |                         | 957        |      |   | 1,246      |  |   | 2,699      | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Net income                                                                     |  | $                       | 8,788      |      | $ | 12,356     |  | $ | 14,031     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Earnings per share (Note 15b):                                                 |  |                         |            |      |   |            |  |   |            | 
|Basic                                                                          |  | $                       | 0.74       |      | $ | 0.89       |  | $ | 0.96       | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Diluted                                                                        |  | $                       | 0.68       |      | $ | 0.85       |  | $ | 0.93       | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Weighted average number of shares used in
  computation of earnings per share: |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Basic                                                                          |  |                         | 11,939,905 |      |   | 13,899,319 |  |   | 14,596,119 | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Diluted                                                                        |  |                         | 12,999,600 |      |   | 14,580,328 |  |   | 15,077,579 | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 

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, except share and per share data

|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|------------------------------------------------------------------------------------------------------------ |  | --------------- | ------ | ------------------------------ | - | ----------------- | - | ------------------------------------- | ---- | --------------------------------------------------- | - | ------------------- | - | ------------------------------ | --------- | ------------------------------ | - | ------ | - | - | ------ | - | - | ------- | -
|                                                                                                             |  | Share
  capital |        | Additional
  paid-in
  capital |   | Treasury
  shares |   | Deferred
  Stock-based
  compensation |      | Accumulated
  other
  comprehensive
  Income (loss) |   | Retained
  earnings |   | Total
  comprehensive
  income |           | Total
  shareholders
  equity |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |  
|Balance as of
  January 1, 2004                                                                              |  | $               | 37     |                                | $ | 36,147            |   | $                                     | (377 | )                                                   | $ |                    |   | $                              | (3,092    | )                              | $ | 8,241  |   |   |        |   | $ | 40,956  |  
|Exercise of stock
  options                                                                                  |  |                 | 2      |                                |   | 3,335             |   |                                       | 377  |                                                     |   |                    |   |                                |          |                                |   | (72    | ) |   |        |   |   | 3,642   |  
|Deferred
  stock-based compensation                                                                          |  |                 |       |                                |   | 214               |   |                                       |     |                                                     |   | (214                | ) |                                |          |                                |   |       |   |   |        |   |   |        |  
|Amortization of
  deferred stock compensation                                                                |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   | 148                 |   |                                |          |                                |   |       |   |   |        |   |   | 148     |  
|Comprehensive
  income:                                                                                      |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Other
  comprehensive loss:                                                                                  |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Unrealized gain
  on available-for-sale marketable securities, net of taxes                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | 223       |                                |   |       |   | $ | 223    |   |   | 223     |  
|Foreign currency
  translation adjustments                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | 85        |                                |   |       |   |   | 85     |   |   | 85      |  
|Unrealized losses
  from hedging transactions                                                                |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (405      | )                              |   |       |   |   | (405   | ) |   | (405    | )
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total other
  comprehensive loss                                                                             |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   | (97    | ) |   |        |  
|Net income                                                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   | 8,788  |   |   | 8,788  |   |   | 8,788   |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total
  comprehensive income                                                                                 |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   | $ | 8,691  |   |   |         |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of
  December 31, 2004                                                                            |  |                 | 39     |                                |   | 39,696            |   |                                       |     |                                                     |   | (66                 | ) |                                | (3,189    | )                              |   | 16,957 |   |   |        |   |   | 53,437  |  
|Issuance of Ordinary
  shares, net                                                                           |  |                 | 5      |                                |   | 38,773            |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   |        |   |   | 38,778  |  
|Exercise of stock
  options                                                                                  |  |                 | **)   |                                |   | 485               |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   |        |   |   | 485     |  
|Amortization of
  deferred stock-based compensation                                                          |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   | 51                  |   |                                |          |                                |   |       |   |   |        |   |   | 51      |  
|Comprehensive
  income:                                                                                      |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Other
  comprehensive loss:                                                                                  |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Unrealized loss
  on available-for-sale marketable securities, net of taxes                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (302      | )                              |   |       |   |   | (302   | ) |   | (302    | )
|Foreign currency
  translation adjustments                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (492      | )                              |   |       |   |   | (492   | ) |   | (492    | )
|Unrealized gain
  from hedging transactions                                                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | 424       |                                |   |       |   |   | 424    |   |   | 424     |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total other
  comprehensive loss                                                                             |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   | (370   | ) |   |        |  
|Net income                                                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   | 12,356 |   |   | 12,356 |   |   | 12,356  |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total
  comprehensive income                                                                                 |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   | $ | 11,986 |   |   |         |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of
  December 31, 2005                                                                            |  |                 | 44     |                                |   | 78,954            |   |                                       |     |                                                     |   | (15                 | ) |                                | (3,559    | )                              |   | 29,313 |   |   |       |   |   | 104,737 |  
|Reclassification of deferred compensation
  to additional paid-in capital due to implementation of SFAS 123R |  |                 |       |                                |   | (15               | ) |                                       |     |                                                     |   | 15                  |   |                                |          |                                |   |       |   |   |       |   |   |         |  
|Stock-based
  compensation expenses                                                                          |  |                 |       |                                |   | 2,268             |   |                                       |     |                                                     |   |                     |   |                                |          |                                |   |       |   |   |       |   |   | 2,268   |  
|Exercise of stock
  options                                                                                  |  |                 | ** )  |                                |   | 835               |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   |       |   |   | 835     |  
|Deferred tax due
  to issuance expenses from previous years                                                  |  |                 |       |                                |   | 397               |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   |       |   |   | 397     |  
|Comprehensive
  income:                                                                                      |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Other
  comprehensive gain:                                                                                  |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Unrealized loss
  on available-for-sale marketable securities, net of taxes                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (56       | )                              |   |       |   |   | (56    | ) |   | (56     | )
|Foreign currency
  translation adjustments                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | 441       |                                |   |       |   |   | 441    |   |   | 441     |  
|Unrealized loss
  from hedging transactions                                                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (4        | )                              |   |       |   |   | (4     | ) |   | (4      | )
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total other comprehensive
  income                                                                           |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   | 381    |   |   |         |  
|Net income                                                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   | 14,031 |   |   | 14,031 |   |   | 14,031  |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total
  comprehensive income                                                                                 |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   | $ | 14,412 |   |   |         |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of
  December 31, 2006                                                                            |  | $               | 44     |                                | $ | 82,439            |   | $                                     |     |                                                     | $ |                    |   | $                              | *) (3,178 | )                              | $ | 43,344 |   |   |        |   | $ | 122,649 |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  

|   |                     
|-- | --------------------
|*) | Composed as follows:

|     |                                                                                            |      |                    |        |   |   |        |  
|---- | ------------------------------------------------------------------------------------------ | ---- | ------------------ | ------ | - | - | ------ | -
|     |                                                                                            |      | As of December 31, |       
|2005 |                                                                                            | 2006
|     |                                                                                            |      |                    |        |   |   |        |  
|     | Accumulated unrealized
  gains from available-for-sale marketable securities, net of taxes |      | $                  | 114    |   | $ | 58     |  
|     | Accumulated unrealized
  gains from hedging transactions                                   |      |                    | 19     |   |   | 15     |  
|     | Accumulated foreign
  currency translation adjustments                                     |      |                    | (3,692 | ) |   | (3,251 | )
|     |                                                                                            |      |                    |       
|     | Accumulated other comprehensive
  loss                                                     |      | $                  | (3,559 | ) | $ | (3,178 | )
|     |                                                                                            |      |                    |        |   |   |        |  

|    |                                      
|--- | -------------------------------------
|**) | Represents
  an amount lower than $1.

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, except share and per share data

|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|-------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | ---- | - | ------- | - | - | ------ | -
|                                                                                             |  | Year ended December 31, |        
|                                                                                             |  |                         |        
|                                                                                             |  | 2004                    |         | 2005 |   | 2006    |  
|                                                                                             |  |                         |         |      |   |         |  
|Cash flows from operating activities:                                                        |  |                         |         |      |   |         |   |   |        |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Net income                                                                                   |  | $                       | 8,788   |      | $ | 12,356  |   | $ | 14,031 |  
|Adjustments required to reconcile net
  income to net cash provided by operating activities: |  |                         |         |      |   |         |   |   |        |  
|Depreciation and amortization                                                                |  |                         | 2,072   |      |   | 1,967   |   |   | 2,416  |  
|Gain from sale of property and equipment                                                     |  |                         | (7      | )    |   | (22     | ) |   | (60    | )
|Accrued interest on available-for-sale
  marketable debt securities                          |  |                         |        |      |   | (262    | ) |   | (240   | )
|Gain from sale of marketable securities                                                      |  |                         |        |      |   |        |   |   | (183   | )
|Other- than- temporary decline in fair
  value for available-for-sale marketable securities  |  |                         |        |      |   | 117     |   |   |       |  
|Increase (decrease) in accrued severance
  pay, net                                          |  |                         | (74     | )    |   | 16      |   |   | (20    | )
|Stock-based compensation expenses                                                            |  |                         | 148     |      |   | 51      |   |   | 2,268  |  
|Deferred income taxes, net                                                                   |  |                         |        |      |   | (803    | ) |   | (354   | )
|Increase in trade receivables                                                                |  |                         | (2,515  | )    |   | (1,619  | ) |   | (2,224 | )
|Decrease (increase) in inventories                                                           |  |                         | 198     |      |   | (1,277  | ) |   | (97    | )
|Increase in other accounts receivable and
  prepaid expenses                                 |  |                         | (1,315  | )    |   | (189    | ) |   | (700   | )
|Increase in trade payables                                                                   |  |                         | 1,160   |      |   | 936     |   |   | 1,321  |  
|Increase in deferred revenues                                                                |  |                         | 1,378   |      |   | 852     |   |   | 528    |  
|Increase in other
  long term liabilities                                                    |  |                         |        |      |   |        |   |   | 1,369  |  
|Increase (decrease) in accrued expenses and
  other accounts payable                         |  |                         | (997    | )    |   | 2,502   |   |   | 840    |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Net cash provided by operating activities                                                    |  |                         | 8,836   |      |   | 14,625  |   |   | 18,895 |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Cash flows from investing activities:                                                        |  |                         |         |      |   |         |   |   |        |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Investment in available-for-sale marketable
  securities                                     |  |                         | (7,000  | )    |   | (40,465 | ) |   | (6,500 | )
|Investment in other assets                                                                   |  |                         |        |      |   |        |   |   | (2,508 | )
|Purchase of property and equipment                                                           |  |                         | (1,237  | )    |   | (2,303  | ) |   | (4,576 | )
|Proceeds from sale of property and
  equipment                                               |  |                         | 15      |      |   | 34      |   |   | 95     |  
|Proceeds from sales of available-for-sale
  marketable securities                            |  |                         |        |      |   |        |   |   | 4,371  |  
|Purchase of intangible assets                                                                |  |                         | (1,220  | )    |   |        |   |   |       |  
|Investment in other companies                                                                |  |                         | (2,376  | )    |   | (850    | ) |   | (1,100 | )
|Proceeds from return on investment of other
  companies                                      |  |                         |        |      |   | 910     |   |   | 1,736  |  
|Payment for the purchase of Aladdin
  Knowledge Espanã, S.L.,(1)                             |  |                         | (1,791  | )    |   |        |   |   |       |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Net cash used in investing activities                                                        |  |                         | (13,609 | )    |   | (42,674 | ) |   | (8,482 | )
|                                                                                             |  |                         |         |      |   |         |   |   |        |  

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, except share and per share data

|                                                               |  |                         |        |      |   |        |   |   |        | 
|-------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------ | 
|                                                               |  | Year ended December 31, |       
|                                                               |  |                         |       
|                                                               |  | 2004                    |        | 2005 |   | 2006   |  
|                                                               |  |                         |        |      |   |        |  
|Cash flows
  from financing activities:                        |  |                         |        |      |   |        |   |   |        | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Proceeds from issuance of shares, net                          |  | $                       |       |      | $ | 38,778 |   | $ |       | 
|Proceeds from exercise of options                              |  |                         | 3,642  |      |   | 485    |   |   | 835    | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Net cash
  provided by financing activities                    |  |                         | 3,642  |      |   | 39,263 |   |   | 835    | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Effect of
  exchange rate changes on cash and cash equivalents |  |                         | 157    |      |   | (101   | ) |   | 60     | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Increase
  (decrease) in cash and cash equivalents             |  |                         | (974   | )    |   | 11,113 |   |   | 11,308 | 
|Cash and
  cash equivalents at the beginning of the year       |  |                         | 18,287 |      |   | 17,313 |   |   | 28,426 | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Cash and
  cash equivalents at the end of the year             |  | $                       | 17,313 |      | $ | 28,426 |   | $ | 39,734 | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Supplemental
  disclosure:                                     |  |                         |        |      |   |        |   |   |        | 
|                                                              
|Cash paid during the year for:                                 |  |                         |        |      |   |        |   |   |        | 
|Income taxes                                                   |  | $                       | 698    |      | $ | 1,058  |   | $ | 2,009  | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Non-cash
  activities:                                         |  |                         |        |      |   |        |   |   |        | 
|                                                              
|Investment in intangible assets                                |  | $                       | 260    |      | $ |       |   | $ |       | 
|                                                               |  |                         |        |      |   |        |   |   |        | 

|    |                                                                                     |  |   |       | 
|--- | ----------------------------------------------------------------------------------- |  | - | ----- | 
|(1) | Payment for purchase of Aladdin Knowledge
  Espanã, S.L., (see Note 1b):            |  |   |       | 
|    |                                                                                     |  |   |       | 
|    | Fair value of assets acquired
  and liabilities assumed at the date of acquisition: |  |   |       | 
|    |                                                                                     |  |   |       | 
|    | Working capital net (excluding cash and
  cash equivalents in the amount of $ 188)  |  | $ | 223   | 
|    | Property and equipment                                                              |  |   | 13    | 
|    | Customer list                                                                       |  |   | 1,151 | 
|    | Goodwill                                                                            |  |   | 404   | 
|    |                                                                                     |  |   |       | 
|    |                                                                                     |  | $ | 1,791 | 
|    |                                                                                     |  |   |       | 

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

- 8 -

---



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

|         |        
|-------- | -------
|NOTE 1:- | GENERAL

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a. | Aladdin
  Knowledge Systems Ltd. and its wholly-owned subsidiaries (collectively, the
  Company or Aladdin) is a global provider of security solutions that
  reduce software theft, authenticate network users and protect against
  unwanted Internet and e-mail content, including spam and viruses. The
  Ordinary shares of the Company are quoted on The Nasdaq National Market
  (Nasdaq) under the symbol ALDN. Since July 28, 2004, the shares are also
  quoted on the Tel Aviv Stock Exchange. The Companys security products are
  organized into two segments: Software Digital Rights Management, or DRM, and
  enterprise security.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | The
  Companys software DRM products allow software publishers to manage licensing
  and distribution of their software while limiting revenue loss from software
  theft and piracy. The HASP products include: HASP HL and HASP NET,
  hardware-based software security systems and HASP SL, a software marketing,
  licensing and distribution platform.                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | Within the enterprise security segment, Aladdin develops and markets
  its patented USB-based eToken hardware and software solution for strong
  authentication and digital identity management using a portable device, and
  the eSafe line of integrated content security solutions that protects PCs and
  networks against viruses, worms, spam, spyware, and non-productive and malicious
  Internet-borne content.                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | The Company
  is dependent upon sole source suppliers for certain key components used in
  its products. Although there are limited number of manufacturers of these
  particular components, the Companys management believes that other suppliers
  could provide similar components at comparable terms. A change in suppliers,
  however, could cause a delay in manufacturing and a possible loss of sales,
  which could adversely affect the operating results of the Company and its
  financial position.                                                                                                                                      
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | b. | Acquisition
  of Aladdin Knowledge Systems España, S.L.:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | On July 16,
  2004, the Company entered into a Share Purchase Agreement with the
  shareholders of its former distributor, Aladdin Knowledge Systems España, S.L
  (Aladdin España), in order to enhance the service provided to
  Spanish-speaking countries. Pursuant to the agreement, the Company acquired
  100% of Aladdin Españas shares, and thereafter it became a wholly-owned
  subsidiary of the Company.                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | The total
  consideration for the purchase of the shares was $ 1,979 (including
  approximately $ 136 acquisition costs).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | Aladdin
  España is engaged in the marketing, distributing, selling, licensing and
  support of certain proprietary software products of the Company in Spain. The
  acquisition has been accounted for using the purchase method of accounting
  and, accordingly, the purchase price has been allocated to the assets
  acquired and the liabilities assumed based on the estimated fair value at the
  date of acquisition. Regarding the allocation of the goodwill, see also Note
  9.                                                                                                                                                              

- 9 -

---



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

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

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

- 10 -

---



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

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

- 11 -

---



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

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | Marketable securities:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | Management
  determines the appropriate classification of its investments in marketable
  debt securities at the time of purchase and re-evaluates such designations as
  of each balance sheet date. During 2006, 2005 and 2004, all marketable
  securities covered by Statement of Financial Accounting Standard No. 115
  Accounting for Certain Investments in Debt and Equity Securities were
  designated as available-for-sale.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | Accordingly,
  these securities are stated at fair value, with unrealized gains and losses
  reported in accumulated other comprehensive loss, a separate component of
  shareholders equity, net of taxes. Realized gains and losses on sales of
  investments, and impairment of investments, as determined on a specific
  identification basis, are included in the consolidated statement of
  operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | FASB Staff
  Position (FSP) No. 115-1, The Meaning of Other-Than-Temporary Impairment
  and Its Application to Certain Investment (FSP 115-1) provides guidance
  for determining when an investment is considered impaired, whether impairment
  is other-than temporary, and measurement of an impairment loss. An investment
  is considered impaired if the fair value of the investment is less than its
  cost. If, after consideration of all available evidence to evaluate the
  realizable value of its investment, impairment is determined to be other
  than- temporary, then an impairment loss should be recognized equal to the
  difference between the investments cost and its fair value. FSP 115-1
  nullifies certain provisions of Emerging Issues Task Force (EITF) Issue No.
  03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to
  Certain Investments (EITF 03-1) while retaining the disclosure
  requirements of EITF 03-1 which the Company adopted in 2003.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | Investment in other
  companies:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | The investment in companies, in which the
  Company holds 20% or more (which are not subsidiaries), is accounted using
  the equity method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | The investment in companies, in which the
  Company holds less than 20%, is stated at cost, since the Company does not
  have the ability to exercise significant influence over operating and financial
  policies of the investees.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | The
  Companys Investment in IDesia Ltd. (IDesia) in which the Company holds
  27.4% is accounted for under the cost method after the Company considers the
  guidance provided within EITF 02-14 Whether an Investor Should Apply the
  Equity Method of Accounting to Company Investments Other than Common Stock.
  The Company determined that since its investment in IDesias Preferred Shares
  is not in-substance common stock, the equity method should not be applied
  (see Note 6b).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | The
  Companys investment in Athena Smartcard Solution Ltd. (Athena) in which
  the Company holds 23.5% was accounted for under the equity method. Since the
  investment was made at the end of the year (November 29, 2006) and due to
  immaterial results in Athenas activity, the Companys implementation of the
  equity method to such investment as of December 31, 2006 was immaterial (see
  Note 6c).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

- 12 -

---



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

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | The
  Companys investment in the other companies is reviewed for impairment
  whenever events or changes in circumstances indicate that the carrying amount
  of an investment may not be recoverable, in accordance with Accounting
  Principle Board Opinion No. 18, The Equity Method of Accounting for
  Investments in Common Stock (APB No. 18) and EITF 03-1, The
  meaning of other-than-temporary impairment and its application to certain investments. (EITF
  03-1)
  As of December 31, 2006, based on managements most recent analysis, no
  impairment losses have been identified.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Inventories:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Inventories
  are stated at the lower of cost or market value. Inventory provisions are
  provided to cover risks arising from slow-moving items, technological
  obsolescence, excess inventories and for market prices lower than cost.                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Cost is
  determined for all types of inventory using the moving average cost method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Property and equipment:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Property and
  equipment are stated at cost, net of accumulated depreciation. Depreciation
  is calculated by the straight-line method over the estimated useful lives of
  the assets, at the following annual rates:                                                                                                                                                                                                                                                                                                                                                                                      

|                                     |  |                                                                 
|------------------------------------ |  | ----------------------------------------------------------------
|                                     |  | %                                                               
|                                     |  |                                                                 
|                                     |  |                                                                 
|Computers
  and peripheral equipment |  | 33                                                              
|Office
  furniture and equipment     |  | 7 - 10 (mainly 7%)                                              
|Motor
  vehicles                     |  | 15                                                              
|Leasehold
  improvements             |  | Over the shorter of the term of the
  lease or useful life lease

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

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

- 13 -

---



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

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | Goodwill:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | Goodwill is
  measured as the excess of the cost of an acquired company over the sum of the
  amounts assigned to tangible and identifiable intangible assets acquired less
  liabilities assumed. Goodwill is not amortized, but rather reviewed for
  impairment at least annually in accordance with the provisions of SFAS No.
  142. The goodwill impairment test under SFAS No. 142 involves a two-step
  approach. Under the first step, the Company determines the fair value of each
  reporting unit to which goodwill has been assigned. The reporting units of
  the Company for purposes of the impairment test are the Companys two
  operating segments, the software security DRM, and enterprise security, as
  these are the components of the business for which discrete financial information
  is available and segment management regularly reviews the operating results
  of those components. The Company then compares the fair value of each
  reporting unit to its carrying value, including goodwill. The Company
  estimates the fair value of each reporting unit by estimating the present
  value of the reporting units future cash flows. If the fair value exceeds
  the carrying value, no impairment loss is recognized. If the carrying value
  exceeds the fair value, the goodwill of the reporting unit is considered
  potentially impaired and the second step is completed in order to measure the
  impairment loss. Under the second step goodwill is reduced to its implied
  fair value through an adjustment to the goodwill balance, resulting in an
  impairment charge. The Company performs the annual impairment tests during
  the fourth fiscal quarter. During 2004, 2005 and 2006, no impairment losses
  were identified.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | Impairment of long-lived assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | The
  long-lived assets of the Company and its subsidiaries and certain
  identifiable intangible assets are reviewed for impairment in accordance with
  Statement of Financial Accounting Standard No. 144 Accounting for the
  Impairment or Disposal of Long-Lived Assets(SFAS No. 144), whenever events
  or changes in circumstances indicate that the carrying amount of an asset may
  not be recoverable. Recoverability of assets to be held and used is measured
  by a comparison of the carrying amount of an asset to the future undiscounted
  cash flows expected to be generated by the assets. If such assets are
  considered to be impaired, the impairment to be recognized is measured by the
  amount by which the carrying amount of the assets exceeds the fair value of
  the assets. During 2004, 2005 and 2006, no impairment losses were identified.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | Income taxes:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | The Company
  and its subsidiaries account for income taxes in accordance with Statement of
  Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS
  No. 109). This Statement prescribes the use of the liability method whereby
  deferred tax assets and liability account balances are determined based on
  the differences between financial reporting and tax bases of assets and
  liabilities and are measured using the enacted tax rates and laws that will
  be in effect when the differences are expected to reverse. The Company and
  its subsidiaries provide a valuation allowance, if necessary, to reduce
  deferred tax assets to the amounts that are more likely-than-not to be
  realized.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

- 14 -

---



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

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

- 15 -

---



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

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

- 16 -

---



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

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Time-based
  licenses including maintenance and on-going support are recognized over the
  term of the agreement. VSOE of fair value does not exist for the related
  support arrangement as maintenance is not priced or offered separately for
  such arrangements. In these cases, the Company recognizes the license and
  maintenance revenue ratably over the period of each arrangement.                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | In certain
  cases where a multiple elements arrangement exist, the fair value of each
  undelivered element is determined based on VSOE for that element and revenue is allocated
  to each undelivered element based upon its fair value. The revenue associated with each
  element is recognized using the respective methodology discussed above. The
  Company uses the residual method in accordance with SOP 97-2.                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Deferred
  revenues include unearned amounts received from maintenance and support
  contracts.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Severance pay:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | The
  Companys liability for its Israeli employees severance pay is calculated
  pursuant to Israels Severance Pay Law, based on the most recent salary of
  the Israeli employees, multiplied by the number of years of employment as of
  balance sheet date. Employees are entitled to one months salary for each
  year of employment, or a portion thereof. The Companys liability for all of
  its employees in Israel is fully provided by monthly deposits with severance
  pay funds, insurance policies and by an accrual. The value of those policies
  is recorded as an asset in the Companys balance sheet.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | The
  deposited funds include profits accumulated up to the balance sheet date. The
  deposited funds may be withdrawn, only upon fulfillment of the obligation
  pursuant to Israels Severance Pay Law or labor agreements. The value of the
  deposited funds is based on the cash surrendered value of these policies, and
  includes immaterial profits.                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Severance
  pay expenses net of fund's profit for the years ended December 31, 2004, 2005
  and 2006 amounted to $ 1,057, $ 1,336 and $ 1,206, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Advertising expenses:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Advertising
  expenses are charged to the statement of operations, as incurred. Advertising
  expenses for the years ended December 31, 2004, 2005 and 2006 were $ 3,488,
  $ 4,504 and $ 4,208 respectively.                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Concentrations of credit risks:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Financial
  instruments that potentially subject the Company to concentrations of credit
  risk consist principally of cash and cash equivalents, marketable securities
  and trade receivables.                                                                                                                                                                                                                                                                                                                                                                                                                               

- 17 -

---



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

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The majority
  of the Companys cash and cash equivalents are invested in U.S. dollar
  deposits with major banks in Israel, the United States, Japan, Germany, the
  Netherlands, United Kingdom, Spain and France. Management believes that the
  financial institutions that hold the Companys investments are financially
  sound and accordingly, minimal credit risk exists with respect to these
  investments. Such cash and cash equivalents in the United States may be in
  excess of insured limits and are not insured in other jurisdictions.                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The
  Companys marketable securities include investments in U.S. Government
  Auction rate, Bonds And Equity securities. Management believes that minimal
  credit risk exists with respect to these marketable securities.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The trade
  receivables of the Company and its subsidiaries are derived from sales to
  customers located primarily in the United States, Europe, Japan and Israel.
  The Company performs ongoing credit evaluations of its customers and, to date
  has not experienced any material losses. An allowance for doubtful accounts
  is determined with respect to those amounts that the Company has determined
  to be doubtful of collection, on a specific account basis.                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The doubtful
  accounts expenses for the years ended December 31, 2004, 2005 and 2006 were
  $ 194, $ 114 and $ 208, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | Basic and diluted earnings per share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | Basic
  earnings per share are computed based on the weighted average number of Ordinary
  shares outstanding during each year. Diluted earnings per share are computed
  based on the weighted average number of Ordinary shares outstanding during
  each year, plus dilutive potential Ordinary shares considered outstanding
  during the year, in accordance with Statement of Financial Accounting
  Standards No. 128, Earnings per Share (SFAS No. 128).                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The total
  weighted average number of outstanding options excluded from the calculations
  of diluted earnings per share was 0, 90,925 and 182,670 for the years ended
  December 31, 2004, 2005 and 2006, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | Accounting for stock-based compensation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | On January
  1, 2006, the Company adopted Statement of Financial Accounting Standards No.
  123 (revised 2004), Share-Based Payment (SFAS 123(R)) which requires the
  measurement and recognition of compensation expense based on estimated fair
  values for all share-based payment awards made to employees and directors.
  SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting
  for Stock Issued to Employees (APB 25), under which the Company previously
  accounted for its share based awards granted to employees and directors, for
  periods beginning in fiscal 2006. In March 2005, the Securities and Exchange
  Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to
  SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption
  of SFAS 123(R).

- 18 -

---



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

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | SFAS 123(R)
  requires companies to estimate the fair value of equity-based payment awards
  on the date of grant using an option-pricing model. The value of the portion
  of the award that is ultimately expected to vest is recognized as an expense
  over the requisite service periods in the Companys consolidated income
  statement. Prior to the adoption of SFAS 123(R), the Company accounted for
  equity-based awards to employees and directors using the intrinsic value
  method in accordance with APB 25 as allowed under Statement of Financial
  Accounting Standards No. 123, Accounting for Stock-Based Compensation
  (SFAS 123).                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The Company
  adopted SFAS 123(R) using the modified prospective transition method, which
  requires the application of the accounting standard starting from January 1,
  2006, the first day of the Companys fiscal year 2006. Under that transition
  method, compensation cost recognized in 2006, includes: (a) compensation cost
  for all share-based payments granted prior to, but not yet vested as of
  January 1, 2006, based on the grant date fair value estimated in accordance
  with the original provisions of Statement 123, and (b) compensation cost for
  all share-based payments granted starting from January 1, 2006, based on the
  grant-date fair value estimated in accordance with the provisions of
  Statement 123(R). Results for prior periods have not been restated.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The Company
  recognizes compensation expenses for the value of its awards, which have
  graded vesting, based on the accelerated attribution method over the vesting
  period, net of estimated forfeitures. Estimated forfeitures are based on
  actual historical pre-vesting forfeitures.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | As a result
  of adopting SFAS 123(R) on January 1, 2006, the Companys income before income
  taxes for 2006, is $ 2,253 lower than if it had continued to account for
  stock-based compensation under APB 25. Net income and net income after tax
  for year ended December 31, 2006, was $ 2,253 lower, than if the Company had
  continued to account for stock-based compensation under APB No. 25. Basic and
  diluted net earnings per share for 2006, are $ 0.15 per share lower, than if
  the Company had continued to account for share-based compensation under APB
  25.                                                                                                                                                                                                                    
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Prior to
  January 1, 2006, the Company applied the intrinsic value method of accounting
  for stock options as prescribed by APB 25, whereby compensation expense is
  equal to the excess, if any, of the quoted market price of the stock over the
  exercise price at the grant date of the award.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The
  Pro-forma table below illustrates the effect of the Companys stock based
  compensation expense on net income and basic and diluted earnings per share
  for 2005 and 2004, had the Company applied the fair value recognition
  provisions of SFAS 123, as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

- 19 -

---



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

|         |                                            
|-------- | -------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)    
|         |                                            
|         | Pro forma
  information under SFAS No. 123:

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

| |                                                                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The fair
  value for options granted in 2004, 2005 is amortized over their vesting
  period and estimated at the date of grant using the Black-Scholes-Merton
  options pricing model with the following weighted average assumptions:

|                               |  |                         |           |      |  |         | 
|------------------------------ |  | ----------------------- | --------- | ---- |  | ------- | 
|                               |  | Year ended December 31, |          
|                               |  |                         |          
|                               |  | 2004                    |           | 2005 | 
|                               |  |                         |           |      | 
|                               |  |                         |           |      |  |         | 
|Expected dividend yield        |  |                         | 0%        |      |  | 0%      | 
|Expected volatility            |  |                         | 75.4%     |      |  | 78.9%   | 
|Risk-free interest rate        |  |                         | 2.8%      |      |  | 3.9%    | 
|Average Expected life of up to |  |                         | 4.5 years |      |  | 6 years | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Pro-forma
  compensation expense under SFAS 123, among other computational differences,
  does not consider potential pre-vesting forfeitures. Because of these
  differences, the pro-forma stock based compensation expense presented above
  for the prior years ended December 31 2004 and 2005 under SFAS 123 and the
  stock based compensation expense recognized during the current year ended
  December 31 2006 under SFAS 123(R) are not directly comparable.

- 20 -

---



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

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The Company
  estimates the fair value of stock options granted using the
  Black-Scholes-Merton option-pricing model. The option-pricing model requires
  a number of assumptions, of which the most significant are, expected stock
  price volatility, and the expected option term. Expected volatility was
  calculated based upon actual historical stock price movements over the most
  recent periods ending December 31, 2006, equal to the expected option term.
  The expected option term represents the period that the Companys stock
  options are expected to be outstanding and was determined based on historical
  experience of similar options, giving consideration to the contractual terms
  of the stock options. The Company has historically not paid dividends and has
  no foreseeable plans to issue dividends. The risk-free interest rate is based
  on the yield from U.S. Treasury zero-coupon bonds with an equivalent term.
  The following weighted assumptions were used in the model for 2006:

|                        |  |          
|----------------------- |  | ---------
|                        |  | 2006     
|                        |  |          
|                        |  |          
|Expected dividend yield |  | 0%       
|Expected volatility     |  | 67.3%    
|Risk-free interest rate |  | 4.6%     
|Expected option term    |  | 4.5 years
|Forfeiture rate         |  | 3.3%     

| |                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | During the year ended December 31 2006, the Company recognized
  stock-based compensation expense related to employee stock options in the
  amount of $ 2,268, as follows:

|                                         |  |                                  |       | 
|---------------------------------------- |  | -------------------------------- | ----- | 
|                                         |  | Year ended
  December 31,
  2006 |      
|                                         |  |                                  |      
|                                         |  |                                  |       | 
|Cost of
  revenue                        |  | $                                | 43    | 
|Research and
  development               |  |                                  | 666   | 
|Selling and
  marketing                  |  |                                  | 732   | 
|General and
  administrative             |  |                                  | 827   | 
|                                         |  |                                  |       | 
|                                         |  |                                  |       | 
|Total
  Stock-based compensation expense |  | $                                | 2,268 | 
|                                         |  |                                  |       | 

| |                                                                                                                                                                                          
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | During the
  years ended December 31 2004 and 2005, the Company recognized general and
  administrative stock-based compensation expense in the amount of $ 148 and
  $ 51, respectively.

- 21 -

---



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

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

- 22 -

---



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

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | All other
  derivatives which do not qualify for hedge accounting under FAS 133, are
  recognized on the balance sheet at their fair value, with changes in the fair
  value carried to the statements of income included in the financial expenses.                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | The Company
  recognized net income (loss) from derivative instruments of $ (437), $ 324 and
  $ 12 during the years ended December 31, 2004, 2005 and 2006, respectively. The
  amount of $ (203), ($ 132) and ($ 23) were offset against the revenues in the
  statement of income during the years ended December 31, 2004, 2005 and 2006,
  respectively and an amount of $ (234), $ 456 and $ 35 was included in financial
  income, net, during the years ended December 31, 2004, 2005 and 2006,
  respectively.                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | The balance
  in accumulated other comprehensive loss related to derivative instruments as
  of December 31, 2006 is expected to be recognized in earnings over the next
  year.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | Impact of recently issued accounting standards:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | In September
  2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS No.
  157). SFAS No. 157 defines fair value, establishes a framework for measuring
  fair value in generally accepted accounting principles and expands disclosures
  about fair value measurements. SFAS No. 157 is effective for financial
  statements issued for fiscal years beginning after November 15, 2007 and
  interim periods within those fiscal years. The Company is currently
  evaluating the impact that SFAS No. 157 will have on its consolidated
  financial statements.                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | In February
  2007, the FASB issued SFAS No. 159 (SFAS No. 159). SFAS No. 159 permits
  companies to choose to measure certain financial instruments and certain
  other items at fair value. SFAS No. 159 requires that unrealized gains and
  losses on items for which the fair value option has been elected be reported
  in earnings. SFAS No. 159 is effective for financial statements issued for
  fiscal years beginning after November 15, 2007 and interim periods within
  those fiscal years, although earlier adoption is permitted. The Company is
  currently evaluating the impact that SFAS No. 159 will have on its
  consolidated financial statements.

- 23 -

---



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

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

|                          |  |                   |        |                            |   |                             |  |                                   |    |  |   |        | 
|------------------------- |  | ----------------- | ------ | -------------------------- | - | --------------------------- |  | --------------------------------- | -- |  | - | ------ | 
|                          |  | December 31, 2006 |       
|                          |  |                   |       
|                          |  | Cost              |        | Gross
  unrealized
  gains |   | Gross
  unrealized
  losses |  | Estimated
  fair
  market
  value |   
|                          |  |                   |        |                            |   |                             |  |                                   |   
|                          |  |                   |        |                            |   |                             |  |                                   |   
|Government
  bonds        |  | $                 | 24,089 |                            | $ | 80                          |  | $                                 | 22 |  | $ | 24,147 | 
|Auction rate
  securities |  |                   | 27,000 |                            |   |                            |  |                                   |   |  |   | 27,000 | 
|                          |  |                   |        |                            |   |                             |  |                                   |    |  |   |        | 
|                          |  |                   |        |                            |   |                             |  |                                   |    |  |   |        | 
|                          |  | $                 | 51,089 |                            | $ | 80                          |  | $                                 | 22 |  | $ | 51,147 | 
|                          |  |                   |        |                            |   |                             |  |                                   |    |  |   |        | 

|                          |  |                   |        |                            |   |                             |  |                                   |     |  |   |        | 
|------------------------- |  | ----------------- | ------ | -------------------------- | - | --------------------------- |  | --------------------------------- | --- |  | - | ------ | 
|                          |  | December 31, 2005 |       
|                          |  |                   |       
|                          |  | Cost              |        | Gross
  unrealized
  gains |   | Gross
  unrealized
  losses |  | Estimated
  fair
  market
  value |    
|                          |  |                   |        |                            |   |                             |  |                                   |    
|                          |  |                   |        |                            |   |                             |  |                                   |    
|Government
  bonds        |  | $                 | 27,110 |                            | $ |                            |  | $                                 | 201 |  | $ | 26,909 | 
|Equity
  securities       |  |                   | 927    |                            |   | 479                         |  |                                   |    |  |   | 1,406  | 
|Auction rate
  securities |  |                   | 20,500 |                            |   |                            |  |                                   |    |  |   | 20,500 | 
|                          |  |                   |        |                            |   |                             |  |                                   |     |  |   |        | 
|                          |  |                   |        |                            |   |                             |  |                                   |     |  |   |        | 
|                          |  | $                 | 48,537 |                            | $ | 479                         |  | $                                 | 201 |  | $ | 48,815 | 
|                          |  |                   |        |                            |   |                             |  |                                   |     |  |   |        | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In November
  2004 and July 2005, the Company invested in U.S. government bonds with
  maturities of up to three and two years, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | In June and
  July 2006 the Company sold its investments in equity securities for total
  consideration of $ 1,372. The net adjustment to unrealized gains (losses) on
  available-for-sale marketable securities was included as a separate component
  of shareholders equity accumulated other comprehensive income (loss) and
  amounted to $ 223, $ (302) and $ (56) in 2004, 2005 and 2006 respectively.                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | According to
  Staff Accounting Bulletin No. 59 (SAB No. 59) and EITF 03-1, The Meaning
  of Other-Than-Temporary Impairment and Its Application to Certain
  Investments, for any marketable securities whose value declined during the
  period, management is required to evaluate whether the decline is other than
  temporary. In 2005, a decline in value that was considered other than
  temporary of one of the Companys available-for-sale securities resulting in
  reversing the accumulated unrealized loss of $ 117 relating to these
  investments. The amount was classified as financial expenses in the
  consolidated statements of income as of December 31, 2005. In 2006, no such
  decline was identified.

- 24 -

---



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

|         |                                                                                          
|-------- | -----------------------------------------------------------------------------------------
|NOTE 3:- | MARKETABLE SECURITIES (Cont.)                                                            
|         |                                                                                          
|         | Aggregate
  maturities of Government bonds for years subsequent to December 31, 2006 are:

|     |  |               |        |                                  |   |        | 
|---- |  | ------------- | ------ | -------------------------------- | - | ------ | 
|     |  | Amortizedcost |        | Estimated
  fair 
  market value |  
|     |  |               |        |                                  |  
|     |  |               |        |                                  |   |        | 
|2007 |  | $             | 24,206 |                                  | $ | 24,147 | 
|     |  |               |        |                                  |   |        | 

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

|                         |  |              |       |      |   |       | 
|------------------------ |  | ------------ | ----- | ---- | - | ----- | 
|                         |  | December 31, |      
|                         |  |              |      
|                         |  | 2005         |       | 2006 |  
|                         |  |              |       |      |  
|                         |  |              |       |      |  
|Loans to employees       |  | $            | 191   |      | $ | 376   | 
|Prepaid expenses         |  |              | 1,877 |      |   | 2,361 | 
|Government
  authorities |  |              | 955   |      |   | 1,114 | 
|Advances for
  suppliers |  |              | 205   |      |   | 200   | 
|Other                    |  |              | 289   |      |   | 202   | 
|                         |  |              |       |      |   |       | 
|                         |  |              |       |      |   |       | 
|                         |  | $            | 3,517 |      | $ | 4,253 | 
|                         |  |              |       |      |   |       | 

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

|                                         |  |              |       |      |   |       | 
|---------------------------------------- |  | ------------ | ----- | ---- | - | ----- | 
|                                         |  | December 31, |      
|                                         |  |              |      
|                                         |  | 2005         |       | 2006 |  
|                                         |  |              |       |      |  
|                                         |  |              |       |      |  
|Raw
  materials, parts and supplies, net |  | $            | 3,047 |      | $ | 3,169 | 
|Work-in-progress                         |  |              | 1,431 |      |   | 1,253 | 
|Finished
  products                      |  |              | 2,520 |      |   | 2,877 | 
|                                         |  |              |       |      |   |       | 
|                                         |  |              |       |      |   |       | 
|                                         |  | $            | 6,998 |      | $ | 7,299 | 
|                                         |  |              |       |      |   |       | 

| |                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------
| | A write-off
  in the amount of $ 275, $ 422 and $ 336 was made by the Company in the years
  2004, 2005 and 2006 respectively.

- 25 -

---



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

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

|                                                              |  |              |         |      |   |          | 
|------------------------------------------------------------- |  | ------------ | ------- | ---- | - | -------- | 
|                                                              |  | December 31, |        
|                                                              |  |              |        
|                                                              |  | 2005         |         | 2006 |  
|                                                              |  |              |         |      |  
|Investment in Tamir Fishman Ventures II,
  LLC (see a below)  |  | $            | *)5,299 |      | $ | *) 4,413 | 
|Investment in IDesia.Ltd. (see b below)                       |  |              | 1,100   |      |   | 1,100    | 
|Investment in Athena Smartcard solutions
  Ltd. (see c below) |  |              |        |      |   | 250      | 
|                                                              |  |              |         |      |   |          | 
|                                                              |  |              |         |      |   |          | 
|                                                              |  | $            | 6,399   |      | $ | 5,763    | 
|                                                              |  |              |         |      |   |          | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | *) | Net of
  impairment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | a. | Investment
  in Tamir Fishman Ventures II, LLC                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | Through
  December 31, 2006, the Company had invested an aggregate amount of $ 8,097 in
  Tamir Fishman Ventures II, LLC (Tamir Fishman). The Company does not have
  the ability to exercise significant influence and therefore the investment
  was stated at cost. See also Note 11c regarding the Companys commitment to
  make additional investments in Tamir Fishman.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | During 2004,
  2005 and 2006, based on managements most recent analysis, no impairment
  losses have been identified.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | In 2005 and
  2006, as a result of exit transactions for portfolio companies of Tamir
  Fishman, the Company received a distribution of $ 910 and $ 1,736 in cash. Distributions received in 2005 and 2006 were recorded as a return of
  investment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | b. | Investment
  in IDesia Ltd..                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | In April
  2004, the Company entered into a convertible loan agreement with IDesia Ltd.
  (IDesia), an Israeli company engaged in the development of biometric
  identity recognition technology. Pursuant to the agreement, the Company
  invested an aggregate amount of $ 1,100 in IDesia (including expenses in the
  amount of $ 50). This investment consisted of a $ 550 convertible loan (the
  Convertible Loan), which would automatically converted into Series A
  preferred shares of IDesia upon the achievement of certain agreed upon
  milestones. Concurrently with the conversion of the loan, the Company
  invested the additional $ 500 by purchasing additional Series A preferred
  shares of IDesia. At December 31, 2004, the Company owned 19.9% of the share
  capital of IDesia. and accounted for this investment under the cost method.

- 26 -

---



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

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

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | During the
  fourth quarter of 2005 IDesia entered into a new Convertible Series A
  Preferred Share Purchase Agreement (the SPA) with a new third party
  investor (the Investor). At the Closing of the SPA, IDesia issued to the
  Company, for no additional consideration, additional Convertible Series A
  Preferred Shares, in such way that the aggregate number of Preferred Shares
  held by the Company at the original 2004 investment of $ 1,050 represents
  27.04% of the share capital of IDesia. The investment is stated at cost,
  since the investment in Preferred shares is not in-substance Common stock
  (see Note 2).                                                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | In October
  2005, the Company signed a license and OEM agreement with IDesia. Under this
  agreement IDesia will develop, manufacture, provide and license to the
  Company certain Chip-Sets as specified in the agreement. According to the
  agreement the Company advanced IDesia $ 200 in consideration for the
  Chip-Sets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | c. | Investment
  in Athena Smartcard Solutions Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | In November 2006 the Company entered into
  an agreement with K.K. Athena Smartcard Solutions Ltd., a Japanese company
  (Athena), whereby the Company was granted an option allowing it to invest
  up to $ 745 in Athena at any time until June 30, 2007, in consideration for
  the issuance of shares of Athena. The option is exercisable in three
  instalments of $ 248 each. Each instalment represents 2.3% of Athenas
  fully diluted share capital. If the Company will complete the three
  instalments, it will hold 27.9% of Athenas share capital.
  An exercise notice for the first instalment was submitted by Aladdin upon
  signing of the agreement. As of December 31, 2006, the Company holds 23.5% of
  Athenas share capital (see Note 2).The Company has invested in
  Athena previously but Athena has incurred losses over the years and Aladdin
  has accordingly reduced its investments and loans in Athena to zero in 2004.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | In October
  2006, the Company entered into License Agreement with Athena. Pursuant to
  this agreement Athena granted Aladdin a worldwide perpetual non revocable,
  transferable, non-exclusive license to use any intellectual property rights,
  including without limitation patents, trade secrets, trademarks and
  copyrights in the Licensed Software for the amount of $ 250. Aladdin can
  solely use the license and market, sublicense, distribute and sell it as
  embedded in or integrated with the Aladdin products. The Company recorded
  this amount in the prepaid expenses according to the relative fair value.                                                                                                                                                                                                                                                                                                                          

- 27 -

---



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

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

|                                   |  |                |        |      |   |        | 
|---------------------------------- |  | -------------- | ------ | ---- | - | ------ | 
|                                   |  | December
  31, |       
|                                   |  |                |       
|                                   |  | 2005           |        | 2006 |  
|                                   |  |                |        |      |  
|Cost:                              |  |                |        |      |   |        | 
|Computers and peripheral equipment |  | $              | 13,136 |      | $ | 14,927 | 
|Office furniture and equipment     |  |                | 1,971  |      |   | 2,363  | 
|Motor vehicles                     |  |                | 462    |      |   | 301    | 
|Leasehold improvements             |  |                | 1,657  |      |   | 1,864  | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                | 17,226 |      |   | 19,455 | 
|                                   |  |                |        |      |   |        | 
|Accumulated depreciation:          |  |                |        |      |   |        | 
|Computers and peripheral equipment |  |                | 11,367 |      |   | 12,463 | 
|Office furniture and equipment     |  |                | 1,453  |      |   | 1,576  | 
|Motor vehicles                     |  |                | 258    |      |   | 174    | 
|Leasehold improvements             |  |                | 1,067  |      |   | 1,290  | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                | 14,145 |      |   | 15,503 | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                |        |      |   |        | 
|Depreciated cost                   |  | $              | 3,081  |      | $ | 3,952  | 
|                                   |  |                |        |      |   |        | 

|         |                                                                                                                                       
|-------- | --------------------------------------------------------------------------------------------------------------------------------------
|         | Depreciation
  expenses for the years ended December 31, 2004, 2005 and 2006 amounted to
  $ 1,463, $ 1,409 and $ 1,833, respectively.
|         |                                                                                                                                       
|NOTE 8:- | INTANGIBLE ASSETS, NET                                                                                                                
|         |                                                                                                                                       
|         | a.                                                                                                                                    

|                                |  |                |       |      |   |       | 
|------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
|                                |  | December
  31, |      
|                                |  |                |      
|                                |  | 2005           |       | 2006 |  
|                                |  |                |       |      |  
|Subject
    to amortization     |  |                |       |      |   |       | 
|Cost:                           |  |                |       |      |   |       | 
|Current technology (1)          |  | $              | 1,054 |      | $ | 1,054 | 
|Customer list (2)               |  |                | 1,151 |      |   | 1,151 | 
|Domain name (3)                 |  |                | 430   |      |   | 430   | 
|Patent (4)                      |  |                | 550   |      |   | 550   | 
|Educational products (5)        |  |                |      |      |   | 2,508 | 
|                                |  |                |       |      |   |       | 
|                                |  |                |       |      |   |       | 
|                                |  |                | 3,185 |      |   | 5,693 | 
|                                |  |                |       |      |   |       | 
|Accumulated amortization:       |  |                |       |      |   |       | 
|Current technology (1)          |  |                | 933   |      |   | 1,054 | 
|Customer list (2)               |  |                | 246   |      |   | 410   | 
|Domain names (3)                |  |                | 223   |      |   | 358   | 
|Patent (4)                      |  |                | 288   |      |   | 326   | 
|                                |  |                |       |      |   |       | 
|                                |  |                |       |      |   |       | 
|                                |  |                | 1,690 |      |   | 2,148 | 
|                                |  |                |       |      |   |       | 
|                                |  |                |       |      |   |       | 
|Amortized cost                  |  | $              | 1,495 |      | $ | 3,545 | 
|                                |  |                |       |      |   |       | 
|                                |  |                |       |      |   |       | 
|Not
    subject to amortization |  |                |       |      |   |       | 
|Cost:                           |  |                |       |      |   |       | 
|Domain name (6)                 |  |                | 500   |      |   | 500   | 
|                                |  |                |       |      |   |       | 
|Intangible assets, net          |  |                | 1,995 |      |   | 4,045 | 
|                                |  |                |       |      |   |       | 

- 28 -

---



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

|         |                               
|-------- | ------------------------------
|NOTE 8:- | INTANGIBLE ASSETS, NET (Cont.)

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Current
  technology - is being amortized over a period of five years and was fully
  amortized in 2006                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (2) | Customer
  list - is being amortized over a period of seven years and will be fully
  amortized in 2011. See also Note 1b for the acquisition of Aladdin Espana.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (3) | Domain names
  - On May 27,
  2004, the Company and Aladdin Systems Holdings Inc. (ASH) entered into a
  settlement agreement (the Agreement). Under the terms of the Agreement, the
  Company agreed to pay ASH $ 550 for the purchase of domain names and for
  reimbursing ASH for the cost of implementing a name change and a re-branding.
  As a result of the Agreement, the Company recorded an amount of $ 430 which
  relates to the acquired domain names, which will be amortized over a period
  of 3 years (will be fully amortized in 2007). The allocation of the
  intangible assets acquired in the Agreement was determined by the Company
  which was assisted by a third-party valuation firm. Out of the $ 550, the
  Company recorded in 2004 an amount of $ 120 as general and administrative
  expenses.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (4) | Patent - is
  being amortized over its useful life and will be fully amortized in 2012.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (5) | As of
  December 31, 2006 the Company has accumulated a total amount of approximately
  $ 2,508 in direct expenses for developing and producing Training in regards to
  certain tender.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (6) | In November
  2004, the Company purchased the URL Aladdin.com for the amount of $ 500.
  According to management, this asset is deemed to have an indefinite useful
  life and is being reviewed annually for impairment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

| |    |                                                                                                                                  
| | -- | ---------------------------------------------------------------------------------------------------------------------------------
| | b. | Amortization
  expenses for the years ended December 31, 2004, 2005 and 2006, amounted to
  $ 609, $ 558 and $ 458, respectively.
| |    |                                                                                                                                  
| | c. | Estimated
  amortization expenses for the next five years:                                                                       

|2007 |  | $ | 756   | 
|---- |  | - | ----- | 
|2008 |  |   | 1,041 | 
|2009 |  |   | 1,041 | 
|2010 |  |   | 553   | 
|2011 |  |   | 133   | 
|     |  |   |       | 

- 29 -

---



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

|         |                                                                                                                                                                                                                                              
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 9:- | GOODWILL                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                              
|         | As fully
  discussed in Note 14, the Company operates in two operating segments which
  are also considered by management as the Companys reporting units. The
  carrying amount of goodwill as of December 31, 2005 and 2006 is as follows:

|                                           |  |   |                                       |  |   |                                 |  |   |       | 
|------------------------------------------ |  | - | ------------------------------------- |  | - | ------------------------------- |  | - | ----- | 
|                                           |  |   | Software
  Security
  (DRM)
  segment |  |   | Enterprise
  Security
  segment |  |   | Total | 
|                                           |  |   |                                       |  |   |                                 |  |   |       | 
|Balance as
  of December 31, 2005 and 2006 |  | $ | 6,845                                 |  | $ | 840                             |  | $ | 7,685 | 
|                                           |  |   |                                       |  |   |                                 |  |   |       | 

|          |                                                |                                                                                                                                     
|--------- | ---------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------
|          |                                                | Goodwill acquired was allocated to reporting units based on the
  expected benefits of the business acquired to each reporting unit.
|          |                                                |                                                                                                                                     
|NOTE 10:- | ACCRUED EXPENSES AND OTHER ACCOUNTS
  PAYABLES

|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
|                                                                                                                                                                                                     |  | December
  31, |      
|                                                                                                                                                                                                     |  |                |      
|                                                                                                                                                                                                     |  | 2005           |       | 2006 |  
|                                                                                                                                                                                                     |  |                |       |      |  
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|Employees
  and payroll accruals                                                                                                                                                                     |  | $              | 4,215 |      | $ | 4,434 | 
|Income taxes
  payable                                                                                                                                                                               |  |                | 2,429 |      |   | 2,535 | 
|Accrued
  expenses *)                                                                                                                                                                                |  |                | 1,072 |      |   | 1,649 | 
|Deferred tax
  liability and other                                                                                                                                                                   |  |                | 83    |      |   |      | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|                                                                                                                                                                                                     |  | $              | 7,799 |      | $ | 8,618 | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|*) Accrued expenses as of December 31, 2006 include a sum of $374 which reflects
  participation in leashold improvement, the Company classified an amount of $1,369 as other long term liabilities. | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 

|          |                                        |                                                                                                                                                                                      
|--------- | -------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 11:- | COMMITMENTS AND CONTINGENT LIABILITIES
|          |                                        |                                                                                                                                                                                      
|          | a.                                     | Lease
  commitments:                                                                                                                                                                 
|          |                                        |                                                                                                                                                                                      
|          |                                        | The
  Companys and its subsidiaries premises and motor vehicles are leased under
  various operating lease agreements which expire on various dates, the latest
  of which is 2011.
|          |                                        |                                                                                                                                                                                      
|          |                                        | Minimum
  lease commitments, under non-cancelable leases as of December 31, 2006, are
  as follows:                                                                                  

|                          |  |            |       |                  |   |       |  |   |       | 
|------------------------- |  | ---------- | ----- | ---------------- | - | ----- |  | - | ----- | 
|                          |  | Facilities |       | Motor
  vehicles |   | Total | 
|                          |  |            |       |                  |   |       | 
|Year ended
  December, 31 |  |            |       |                  |   |       |  |   |       | 
|2007                      |  | $          | 2,044 |                  | $ | 1,122 |  | $ | 3,166 | 
|2008                      |  |            | 1,622 |                  |   | 756   |  |   | 2,378 | 
|2009                      |  |            | 1,548 |                  |   | 277   |  |   | 1,825 | 
|2010                      |  |            | 1,255 |                  |   | 2     |  |   | 1,257 | 
|2011                      |  |            | 834   |                  |   |      |  |   | 834   | 
|Later years               |  |            | 79    |                  |   |      |  |   | 79    | 
|                          |  |            |       |                  |   |       |  |   |       | 
|                          |  |            |       |                  |   |       |  |   |       | 
|                          |  | $          | 7,382 |                  | $ | 2,157 |  | $ | 9,539 | 
|                          |  |            |       |                  |   |       |  |   |       | 

- 30 -

---



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

|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--------- | ---------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 11:- | COMMITMENTS AND CONTINGENT LIABILITIES (Cont.)
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | Facilities
  lease expenses for the years ended December 31, 2004, 2005 and 2006 were
  approximately $ 1,941, $ 1,785 and $ 2,065, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | Motor
  vehicle lease expenses for the years ended December 31, 2004, 2005 and 2006
  were approximately $ 1,081, $ 1,294 and $ 1,535, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | b.                                             | Litigation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | In April
  2005, the Company settled a patent infringement lawsuit. The lawsuit was
  originally brought by Andrew Pickholtz against the Company and its U.S.
  subsidiary on May 19, 2004 in the U.S. District Court for the Northern
  District of California, alleging that the Companys discontinued MicroGuard
  product and other Software Digital Rights Management products infringed an
  expired patent. An affiliate of Rainbow Technologies was subsequently added
  as a plaintiff.                                                                                                                                     
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | On April 6,
  2005, the parties reached a settlement agreement, under which the Company
  agreed to pay $ 2,000 to settle the lawsuit. The Company recorded the
  settlement cost as a one-time charge within its operating expenses. There
  will be no ongoing license or other fees payable by the Company in connection
  with the settlement.                                                                                                                                                                                                                                                                                    
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | c.                                             | Investment
  commitment:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | In February
  2000, the Company signed an agreement with Tamir Fishman. Pursuant to the
  agreement, the Company committed to invest up to $8,525 on demand from Tamir
  Fishman, out of which, as of December 31, 2006, the Company had already
  invested $ 8,097                                                                                                                                                                                                                                                                                                                                                                   
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|NOTE 12:- | TAXES ON INCOME                               
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | a.                                             | Reduction in
  Israeli tax rates:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | In June 2004
  and in July 2005, the Knesset (Israeli parliament) passed amendments to the
  Income Tax Ordinance (No. 140 and Temporary Provision), 2004 and (No. 147),
  2005 respectively, which determine, among other things, that the corporate
  tax rate is to be gradually reduced to the following tax rates: 2004 - 35%,
  2005 - 34%, 2006 - 31%, 2007 - 29%, 2008 - 27%, 2009 - 26% and 2010 and
  thereafter - 25%.                                                                                                                                                                                                   
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | b.                                             | Tax benefits
  under the Law for the Encouragement of Capital Investments, 1959 (the Law):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | The
  Companys production facilities have been granted Approved Enterprise
  status under the Law currently under seven separate investment programs.
  Pursuant to the Law, the Company has elected the alternative benefits track
  and has waived Government grants in return for a tax exemption. The main
  benefit arising from such status is the reduction in tax rates on income
  derived from Approved Enterprises. Consequently, the Company is entitled to
  a two-year tax exemption and five to eight years of tax at a reduced rate of
  10%-25%, based on the percentage of foreign investment in the Company.

- 31 -

---



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

|          |                
|--------- | ---------------
|NOTE 12:- | TAXES ON INCOME

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | By virtue of
  this law, the Company is entitled to claim accelerated depreciation on
  equipment used by the Approved Enterprise during five tax years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | For the
  Companys seven investment programs, the tax benefits are as follows: Income
  derived from the investment programs, is tax exempt for the first two years
  of the 10-year tax benefit period, and is entitled to a reduced tax rate of
  10%-25% during the remaining benefit period (based on the percentage of
  foreign ownership in each taxable year).                                                                                                                                                                                                                                                                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | The period
  of tax benefits detailed above is subject to time limits of the earlier of 12
  years from commencement of production, or 14 years from receiving the
  approval. Accordingly, the period of benefits relating to all investment
  programs will expire in the years 2005 through 2015.                                                                                                                                                                                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | In 1996, the
  Company relocated its manufacturing activity to a new plant which was
  established in a region defined as a Priority A Development Region. This
  development region entitles Aladdin Israel to higher tax benefits than the
  tax benefits existing where the Companys offices and research and
  development center are located. The main benefit is that the Company is
  tax-exempt for a benefit period of 10 years.                                                                                                                                                                                                                                                                       
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | The
  allocation of the income tax between the priority regions is calculated by a
  formula that was authorized by Israel Tax Authority.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | On April 1,
  2005, an amendment to the Investment Law came into effect (the Amendment)
  and has significantly changed the provisions of the Investment Law. The
  Amendment limits the scope of enterprises which may be approved by the
  Investment Center by setting criteria for the approval of a facility as a
  Privileged Enterprise, such as provisions generally requiring that at least
  25% of the Privileged Enterprises income will be derived from export.
  Additionally, the Amendment enacted major changes in the manner in which tax
  benefits are awarded under the Investment Law so that companies no longer
  require Investment Center approval in order to qualify for tax benefits.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | However, the
  Investment Law provides that terms and benefits included in any certificate
  of approval already granted will remain subject to the provisions of the law
  as they were on the date of such approval.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | As of
  December 31, 2006, retained earnings included approximately $ 44,016 in
  tax-exempt profits earned by the Companys Approved and Privileged
  Enterprises. The Company has decided not to declare dividends out of such
  tax-exempt income. Accordingly, no deferred income taxes have been provided
  on income attributable to the Companys Approved Enterprise.                                                                                                                                                                                                                                                                                                                                    
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | If the
  retained tax-exempt income is distributed, it would be taxed at the corporate
  tax rate applicable to such profits as if the Company had not elected the
  alternative tax benefits (10% to 25%) and an income tax liability of up to
  approximately $ 6,602 would be incurred as of December 31, 2006.                                                                                                                                                                                                                                                                                                                                                                                                   

- 32 -

---



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

|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--------- | ----------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 12:- | TAXES ON INCOME (Cont.)
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | The
  entitlement to the above benefits is conditional upon the Companys
  fulfillment of the conditions stipulated by the above law, regulations
  published thereunder and the instruments of approval for the specific
  investments in Approved Enterprises. In the event of failure to comply with
  these conditions, the benefits may be cancelled and the Company may be
  required to refund the amount of the benefits, in whole or in part, including
  interest.                                                                                                                                                                                                                                
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Management
  believes that as of December 31, 2006, the Company met all of the
  aforementioned conditions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Income from
  sources other than the Approved Enterprise during the benefit period will
  be subject to tax at the statutory corporate tax rate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Since the
  Company is operating under more than one approved program and since part of
  its taxable income is not entitled to tax benefits under the aforementioned
  law and is taxed at the statutory corporate tax rate of 31% (see also Note
  12a) its effective tax rate is the result of a weighted combination of the
  various applicable rates and tax exemptions, and the computation is made for
  income derived from each program on the basis of formulas specified in the
  law and in the approvals.                                                                                                                                                                                        
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          | c.                      | Measurement
  of taxable income under the Income Tax (Inflationary Adjustments) Law, 1985:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Until the
  year 2005, results for tax purposes are measured and reflected in real terms
  in accordance with the change in Israels Consumer Price Index (CPI). As
  explained in Note 2, the consolidated financial statements are presented in
  U.S. dollars. The differences between the change in Israelis CPI and in the
  NIS/dollar exchange rate causes a further difference between taxable income
  and the income before taxes reflected in the consolidated financial
  statements. In accordance with paragraph 9(f) of SFAS No. 109, the Company
  has not provided deferred income taxes on the difference between the
  functional currency and the tax bases of assets and liabilities.
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          | d.                      | Measurement
  of taxable income:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Commencing
  in taxable year 2006, the Company has elected to measure its taxable income
  and file its tax return under the Israeli Income Tax Regulations (Principles
  Regarding the Management of Books of Account of Foreign Invested Companies
  and Certain Partnerships and the Determination of Their Taxable Income),
  1986.  Accordingly, commencing taxable
  year 2006, results for tax purposes are measured in terms of earnings in
  dollar.                                                                                                                                                                                                                                                  
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          | e.                      | Tax benefits
  under Israels Law for the Encouragement of Industry (Taxation), 1969:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         
|          |                         | The Company
  is an Industrial company, as defined by the Law for the Encouragement of
  Industry (Taxes), 1969 and as such, is entitled to certain tax benefits,
  mainly amortization of costs relating to know-how and patents over eight
  years and accelerated depreciation.                                                                                                                                                                                                                                                                                                                                                                                                                           

- 33 -

---



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

|          |                        
|--------- | -----------------------
|NOTE 12:- | TAXES ON INCOME (Cont.)

| |    |                                               
| | -- | ----------------------------------------------
| | f. | Income
  before taxes is comprised as follows:

|         |  |                         |       |      |   |        |  |   |        | 
|-------- |  | ----------------------- | ----- | ---- | - | ------ |  | - | ------ | 
|         |  | Year ended December 31, |      
|         |  |                         |      
|         |  | 2004                    |       | 2005 |   | 2006   | 
|         |  |                         |       |      |   |        | 
|         |  |                         |       |      |   |        |  |   |        | 
|Domestic |  | $                       | 6,572 |      | $ | 8,809  |  | $ | 13,583 | 
|Foreign  |  |                         | 3,173 |      |   | 4,793  |  |   | 3,147  | 
|         |  |                         |       |      |   |        |  |   |        | 
|         |  |                         |       |      |   |        |  |   |        | 
|         |  | $                       | 9,745 |      | $ | 13,602 |  | $ | 16,730 | 
|         |  |                         |       |      |   |        |  |   |        | 

| |    |                                                                                                                        
| | -- | -----------------------------------------------------------------------------------------------------------------------
| | g. | The income
  tax provision (benefit) for the years ended December 31, 2004, 2005 and 2006
  consisted of the following:

|                                |  |   |     |  |   |       |   |   |       |  
|------------------------------- |  | - | --- |  | - | ----- | - | - | ----- | -
|Current                         |  | $ | 957 |  | $ | 1,785 |   | $ | 3,062 |  
|Taxes in respect of prior years |  |   |    |  |   | 264   |   |   | (9    | )
|Deferred                        |  |   |    |  |   | (803  | ) |   | (354  | )
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  | $ | 957 |  | $ | 1,246 |   | $ | 2,699 |  
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  |   |     |  |   |       |   |   |       |  
|Domestic                        |  | $ | 723 |  | $ | 583   |   | $ | 2,933 |  
|Foreign                         |  |   | 234 |  |   | 663   |   |   | (234  | )
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  | $ | 957 |  | $ | 1,246 |   | $ | 2,699 |  
|                                |  |   |     |  |   |       |   |   |       |  

- 34 -

---



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

|          |                         |                                                                                                                                                                                                                                                                                                                     
|--------- | ----------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 12:- | TAXES ON INCOME (Cont.)
|          |                         |                                                                                                                                                                                                                                                                                                                     
|          | h.                      | Deferred
  income taxes:                                                                                                                                                                                                                                                                                            
|          |                         |                                                                                                                                                                                                                                                                                                                     
|          |                         | Deferred
  income taxes reflect the net tax effects of temporary differences between the
  carrying amounts of assets and liabilities for financial reporting purposes
  and the amounts used for income tax purposes. Significant components of the
  Companys deferred tax liabilities and assets are as follows:

|                                                                                |  |              |        |      |   |        |  
|------------------------------------------------------------------------------- |  | ------------ | ------ | ---- | - | ------ | -
|                                                                                |  | December 31, |       
|                                                                                |  |              |       
|                                                                                |  | 2005         |        | 2006 |  
|                                                                                |  |              |        |      |  
|Deferred tax assets (short term):                                               |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Reserves and allowances                                                         |  | $            | 1,202  |      | $ | 1,489  |  
|Net operating loss carry forwards in
  subsidiaries                             |  |              | 9,127  |      |   | 8,924  |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Net deferred tax assets before valuation
  allowance                            |  |              | 10,329 |      |   | 10,413 |  
|Valuation allowance                                                             |  |              | (7,953 | )    |   | (7,292 | )
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Total deferred tax assets                                                       |  |              | 2,376  |      |   | 3,121  |  
|                                                                                |  |              |        |      |   |        |  
|Deferred tax liability from unrealized gain
  on available- for-sale securities |  |              | (53    | )    |   |       |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Total deferred tax liability                                                    |  |              | (53    | )    |   |       |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Net deferred tax assets                                                         |  | $            | 2,323  |      | $ | 3,121  |  
|                                                                                |  |              |        |      |   |        |  
|Domestic:                                                                       |  |              |        |      |   |        |  
|Current deferred tax asset                                                      |  | $            | 767    |      | $ | 1,013  |  
|Current deferred tax liability, net                                             |  |              | (53    | )    |   |       |  
|Non current deferred tax asset                                                  |  |              | 434    |      |   | 476    |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              | 1,148  |      |   | 1,489  |  
|                                                                                |  |              |        |      |   |        |  
|Foreign:                                                                        |  |              |        |      |   |        |  
|Current deferred tax asset, net                                                 |  |              | 391    |      |   | 514    |  
|Non current deferred tax asset                                                  |  |              | 784    |      |   | 1,118  |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              | 1,175  |      |   | 1,632  |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  | $            | 2,323  |      | $ | 3,121  |  
|                                                                                |  |              |        |      |   |        |  

| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Current deferred tax
  liability, net, is included within accrued expenses and other liabilities in
  the balance sheets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | In
  assessing the realization of deferred tax assets, management considers whether
  it is more likely than not that all or some portion of the deferred tax
  assets will not be realized. The ultimate realization of the deferred tax
  assets is dependent upon the generation of future taxable income during the
  periods in which temporary differences are deductible and net operating
  losses are utilized. Based on consideration of these factors, the Company has
  established a valuation allowance of $ 7,953 and $ 7,292 at December 31,
  2005 and 2006, respectively.

- 35 -

---



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

|          |                         |                                                                                                                                                                                                                                                                                                                
|--------- | ----------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 12:- | TAXES ON INCOME (Cont.)
|          |                         |                                                                                                                                                                                                                                                                                                                
|          |                         | The
  Companys subsidiaries in the United Kingdom, Netherlands and Germany have
  estimated total available carry-forward tax losses of $ 1214, $ 2,091 and
  $ 7,906, respectively, to offset against future tax profits for an indefinite
  period.                                                         
|          |                         |                                                                                                                                                                                                                                                                                                                
|          |                         | The
  Companys subsidiaries in the United States and in France have estimated
  total available carry-forward tax losses as of December 31, 2006 of $15,380
  and $321, respectively, to offset against future tax profits for periods of
  15 to 20 years and five years, respectively.                      
|          |                         |                                                                                                                                                                                                                                                                                                                
|          |                         | Utilization
  of U.S. net operating losses may be subject to substantial annual limitations
  due to the change in ownership provisions of the Internal Revenue Code of
  1986 and similar state provisions. The annual limitation may result in the
  expiration of net operating losses before utilization.
|          |                         |                                                                                                                                                                                                                                                                                                                
|          | i.                      | A reconciliation
  between the theoretical tax expense, assuming all income is taxed at the
  statutory tax rate applicable to income of the Company and the actual tax
  expense as reported in the statement of income, is as follows:                                                                       

|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |       |  
|------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------- | ----------------------- | ------ | ----- | - | ------ | ----- | - | ------ | ----- | -
|                                                                                                  |                                                                                       | Year ended December 31, |       
|                                                                                                  |                                                                                       |                         |       
|                                                                                                  |                                                                                       | 2004                    |        | 2005  |   | 2006   |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |      
|Income before taxes, as reported in the
  consolidated statements of income                       |                                                                                       | $                       | 9,745  |       | $ | 13,602 |       | $ | 16,730 |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|Statutory tax rate                                                                                |                                                                                       |                         | 35     | %     |   | 34     | %     |   | 31     | %    
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|Expense computed at the statutory tax rate                                                        |                                                                                       | $                       | 3,411  |       | $ | 4,625  |       | $ | 5,186  |      
|Decrease in taxes resulting from Approved
  Enterprise and Privileged Enterprise benefits (1) |                                                                                       |                         | (353   | )     |   | (1,813 | )     |   | (1,774 | )    
|Tax adjustment in respect of foreign
  subsidiary different tax rate                              |                                                                                       |                         | 20     |       |   | 17     |       |   | (10    | )    
|Change in valuation allowance                                                                     |                                                                                       |                         | (284   | )     |   | 15     |       |   | (661   | )    
|Utilization of loss carry-forward                                                                 |                                                                                       |                         | (1,798 | )     |   | (1,261 | )     |   | (1,001 | )    
|Items for which no deferred tax was recorded                                                      |                                                                                       |                         | (214   | )     |   | (918   | )     |   | (396   | )    
|Taxes in respect of prior years                                                                   |                                                                                       |                         |       |       |   | 264    |       |   | (9     | )    
|Stock compensation relating to options per
  SFAS 123(R)- Non-deductible expenses                 |                                                                                       |                         |       |       |   |       |       |   | 695    |      
|Other non-deductible expenses                                                                     |                                                                                       |                         | 159    |       |   | 320    |       |   | 501    |      
|Other                                                                                             |                                                                                       |                         | 16     |       |   | (3     | )     |   | 168    |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|Actual tax expense                                                                                |                                                                                       | $                       | 957    |       | $ | 1,246  |       | $ | 2,699  |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|(1)                                                                                               | Per share amounts (basic) of the tax
  benefit resulting from Approved Enterprise   |                         | $      | (0.03 | ) | $      | (0.13 | ) | $      | (0.12 | )
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|                                                                                                  | Per share amounts (diluted) of the tax
  benefit resulting from Approved Enterprise |                         | $      | (0.03 | ) | $      | (0.12 | ) | $      | (0.12 | )
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |       |  

- 36 -

---



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

|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|--------- | -------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 13:- | SHAREHOLDERS EQUITY
|          |                     
|          | a.                   | The Ordinary
  shares confer upon their holders the right to receive notice to participate
  and vote in general meetings of the Company, and the right to receive
  dividends, if declared.                                                                                                                                                                                                                                                                                                                                                                                                            
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | b.                   | In October
  2001, the Company initiated a share repurchase program, in which the Company
  is authorized to purchase up to $ 3,000 of its outstanding Ordinary shares,
  through an open-market transaction. As of December 31, 2002, the Company
  purchased 224,100 of its outstanding Ordinary shares, at a weighted average
  price per share of $ 5.20. During 2004, all the shares were reissued from the
  share repurchase program.                                                                                                                                                            
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                      | Such
  repurchases of Ordinary shares are accounted for as Treasury shares, and
  result in a reduction of shareholders equity. When treasury shares are
  reissued, the Company accounts for the re-issuance in accordance with
  Accounting Principles Board Opinion No. 6 Status of Accounting Research
  Bulletins (APB No. 6) and charges the excess of the repurchase cost over
  issuance price using the weighted average method to retained earnings. In case
  the repurchase cost is lower than the issuance price, the Company credits the
  excess cost to additional paid-in capital.
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | c.                   | In March
  2005, the Company closed its secondary public offering of its Ordinary shares
  on Nasdaq. The Company issued 2,000,000 Ordinary shares, in consideration of
  approximately $ 38,778, net of issuance expenses in the amount of $ 4,127.                                                                                                                                                                                                                                                                                                                                                    
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | d.                   | As a result
  of a grant of 100,000 options to the Companys Chief Executive Officer, the
  Company recorded in 2004 deferred compensation in the amount of $ 153, out of
  which an amount of $ 87, $ 51 and $ 15 was recorded as compensation expenses in
  the years 2004, 2005 and 2006, respectively.                                                                                                                                                                                                                                                                                              
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | e.                   | Employee
  Share Option Plans:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                      | Between 1993
  and 2006, the Company implemented several Employee Share Options Plans (the
  plans). Total number of options authorized for grant under the plans
  amounted to 3,523,750. As of December 31, 2006, an aggregate of 282,636
  options of the Company are still available for future grants.                                                                                                                                                                                                                                                                                           
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                      | Under the
  Companys plans, full-time employees, officers and directors of the Company
  may be granted options to acquire Ordinary shares. The options granted are at
  an exercise price that equals the fair market value or the price of the
  shares at the date of grant. The options generally vest over a period of two
  to four years from the date of grant, and expire no later than five or ten
  years from the date of grant. Any options that are canceled or forfeited
  before expiration become available for future grants.                                                        

- 37 -

---



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

|          |                              |                                                                                                                                  
|--------- | ---------------------------- | ---------------------------------------------------------------------------------------------------------------------------------
|NOTE 13:- | SHAREHOLDERS EQUITY (Cont.)
|          |                              |                                                                                                                                  
|          |                              | A summary of
  the Companys stock option activity and related information for the year
  ended December 31, 2006, is as follows:

|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|-------------------------------- |  | -------------------- | --------- | -------------------------------------- | - | ----------------------------------------------------------------- |  | ----------------------------- | ---- |  | - | ----- | 
|                                 |  | Number of 
  options |           | Weighted-
  average
  exercise
  price |   | Weighted-
  average
  remaining
  contractual
  term (in
  years) |  | Aggregate
  intrinsic
  value |     
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |     
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|Outstanding at January 1, 2006   |  |                      | 1,089,206 |                                        | $ | 8.81                                                              |  |                               |      |  |   |       | 
|Granted                          |  |                      | 367,400   |                                        | $ | 17.56                                                             |  |                               |      |  |   |       | 
|Exercised                        |  |                      | (198,425  | )                                      | $ | 4.21                                                              |  |                               |      |  |   |       | 
|Forfeited                        |  |                      | (151,050  | )                                      | $ | 15.43                                                             |  |                               |      |  |   |       | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|Outstanding at December 31, 2006 |  |                      | 1,107,131 |                                        | $ | 11.63                                                             |  |                               | 7.27 |  | $ | 9,107 | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|Vested and expected to vest      |  |                      | 991,951   |                                        | $ | 10.95                                                             |  |                               | 7.12 |  | $ | 8,807 | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|Exercisable at December 31, 2006 |  |                      | 531,230   |                                        | $ | 5.24                                                              |  |                               | 5.94 |  | $ | 7,611 | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 

| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The weighted-average
  grant-date fair value of options granted during the twelve months ended
  December 31, 2006 was $ 10.04. The aggregate intrinsic value in the table
  above represents the total intrinsic value (the difference between the fair
  market value of the Company ordinary shares on December 31, 2006 and the
  exercise price, multiplied by the number of in-the-money options) that would
  have been received by the option holders had all option holders exercised
  their options on December 31, 2006. Total intrinsic value of options
  exercised for the twelve months ended December 31, 2006 was $3,030. As
  of December 31, 2006, there was $ 3,366 of total unrecognized compensation
  cost related to non-vested share-based compensation arrangements granted
  under the Companys stock option plans. That cost is expected to be
  recognized over a weighted-average period of 3.55 years. Total grant-date
  fair value of vested options for the twelve months ended December 31, 2006
  was approximately $2,253.
| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Cash
  received from exercise of options for the years ended December 31, 2004, 2005
  and 2006 were approximately $ 3,642, $ 485 and $ 835, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

- 38 -

---



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

|          |                              |                                                                                                              
|--------- | ---------------------------- | -------------------------------------------------------------------------------------------------------------
|NOTE 13:- | SHAREHOLDERS EQUITY (Cont.)
|          |                             
|          |                              | A summary of
  the Companys share option activity under the plans for the years 2004, 2005
  are as follows:

|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 
|------------------------------------------ |  | ------------------- | --------- | ------------------------------------- | - | ------------------- |  | ------------------------------------- | --------- | - | - | ----- | 
|                                           |  | 2004                |           | 2005                                  |  
|                                           |  |                     |           |                                       |  
|                                           |  | Number
  of options |           | Weighted
  average
  exercise
  price |   | Number
  of options |  | Weighted
  average
  exercise
  price |          
|                                           |  |                     |           |                                       |   |                     |  |                                       |          
|                                           |  |                     |           |                                       |   |                     |  |                                       |          
|Outstanding - beginning of the year        |  |                     | 1,938,195 |                                       | $ | 3.73                |  |                                       | 1,072,454 |   | $ | 5.57  | 
|Granted                                    |  |                     | 157,100   |                                       | $ | 15.10               |  |                                       | 230,950   |   | $ | 20.33 | 
|Exercised                                  |  |                     | (940,234  | )                                     | $ | 3.91                |  |                                       | (139,527  | ) | $ | 3.48  | 
|Forfeited                                  |  |                     | (82,607   | )                                     | $ | 3.68                |  |                                       | (74,671   | ) | $ | 7.80  | 
|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 
|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 
|Outstanding - end of the year              |  |                     | 1,072,454 |                                       | $ | 5.57                |  |                                       | 1,089,206 |   | $ | 8.81  | 
|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 
|Options exercisable at the end of the year |  |                     | 453,712   |                                       | $ | 3.22                |  |                                       | 588,519   |   | $ | 4.39  | 
|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 

| |  |                                                                                                                     
| |  | --------------------------------------------------------------------------------------------------------------------
| |  | The options
  outstanding as of December 31, 2006, have been separated into exercise price
  categories, as follows:

|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  |  |         |  |   |       | 
|--------------------------- | --------------- | --------------------------------------------------- |  | ----------------------------------------------------------- |  | ------------------------------------- |  | --------------------------------------------------- | ----- | ---------------------------------------------------------------- |  | ------- |  | - | ----- | 
|Range of
  exercise
  price |                 | Options
  outstanding
  as of
  December 31,
  2006 |  | Weighted
  average
  remaining
  contractual
  life (years) |  | Weighted
  average
  exercise
  price |  | Options
  exercisable
  as of
  December 31,
  2006 |       | Weighted
  average
  exercise
  price of
  options
  exercisable | 
|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  | 
|$                           | 1.20-
  2.67    |                                                     |  | 258,393                                                     |  | 6                                     |  | $                                                   | 1.75  |                                                                  |  | 249,668 |  | $ | 1.72  | 
|$                           | 3.50-
  4.80    |                                                     |  | 121,488                                                     |  | 4                                     |  | $                                                   | 4.40  |                                                                  |  | 113,188 |  | $ | 4.37  | 
|$                           | 8.51
  - 8.52   |                                                     |  | 132,550                                                     |  | 7                                     |  | $                                                   | 8.51  |                                                                  |  | 112,849 |  | $ | 8.51  | 
|$                           | 13.05-
  15.50  |                                                     |  | 137,700                                                     |  | 8                                     |  | $                                                   | 14.45 |                                                                  |  | 45,025  |  | $ | 14.59 | 
|$                           | 16.23
  - 18.00 |                                                     |  | 262,600                                                     |  | 9                                     |  | $                                                   | 17.43 |                                                                  |  | 2,500   |  | $ | 18.00 | 
|$                           | 20.50
  - 24.27 |                                                     |  | 194,400                                                     |  | 8                                     |  | $                                                   | 21.58 |                                                                  |  | 8,000   |  | $ | 24.27 | 
|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  |  |         |  |   |       | 
|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  |  |         |  |   |       | 
|                            |                 |                                                     |  | 1,107,131                                                   |  |                                       |  | $                                                   | 11.63 |                                                                  |  | 531,230 |  | $ | 5.24  | 
|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  |  |         |  |   |       | 

| |    |                                                                                                                                                                                                              
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | f. | Dividends:                                                                                                                                                                                                   
| |    |                                                                                                                                                                                                              
| |    | In the event
  that cash dividends are declared in the future, such dividends will be paid
  in NIS. Based on its BOD decision the Company does not intend to pay cash
  dividends in the foreseeable future.

- 39 -

---



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

|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                               
|--------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------
|NOTE 14:- | SEGMENTS OF THE COMPANY AND RELATED INFORMATION                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          | Commencing
  January 2004, the Company has two reportable segments related to continuing
  operations. The Software Security Digital Rights Management (DRM) Division
  develops and markets the following products: HASP HL and HASP NET,
  hardware-based software security systems, and HASP SL, a software marketing,
  licensing and distribution platform. Both the software and the hardware
  products allow software publishers to manage licensing and distribution of
  their software theft and piracy.
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          | The
  Enterprise Security Division develops and markets the USB-based eToken
  hardware device for user authentication and the eSafe line of content
  security solutions that protect PCs and networks against viruses, worms, spam
  and non-productive Internet-born content.                                                                                                                                                                                                                                   
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          | The segments
  are managed separately because each segment requires different technology and
  marketing strategies. The Software Security (DRM) Division and Enterprise
  Security Division include some international sales mainly to the United
  States, Europe, and Japan.                                                                                                                                                                                                                                    
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          | a.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | The following
  presents segment results of operations for the years ended December 31, 2004,
  2005 and 2006:

|                                             |  |                         |        |      |   |        |   |   |           |  
|-------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ | - | - | --------- | -
|                                             |  | Year ended December 31, |       
|                                             |  |                         |       
|                                             |  | 2004                    |        | 2005 |   | 2006   |  
|                                             |  |                         |        |      |   |        |  
|Revenues
  from external customers:          |  |                         |        |      |   |        |   |   |           |  
|Software security (DRM)                      |  | $                       | 50,650 |      | $ | 56,578 |   | $ | 60,556    |  
|Enterprise security                          |  |                         | 18,471 |      |   | 25,195 |   |   | 28,482    |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Consolidated
  revenues                      |  | $                       | 69,121 |      | $ | 81,773 |   | $ | 89,038    |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Gross
  profit:                              |  |                         |        |      |   |        |   |   |           |  
|Software security (DRM)                      |  | $                       | 41,109 |      | $ | 46,708 |   | $ | 51,264    |  
|Enterprise security                          |  |                         | 14,231 |      |   | 18,094 |   |   | 17,761    |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Consolidated
  gross profit                  |  | $                       | 55,340 |      | $ | 64,802 |   | $ | 69,025    |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Operating
  income:                          |  |                         |        |      |   |        |   |   |           |  
|Software security (DRM)                      |  | $                       | 17,779 |      | $ | 20,501 |   | $ | 24,135    |  
|Enterprise security                          |  |                         | (7,949 | )    |   | (7,951 | ) |   | (10,929   | )
|                                             |  |                         |        |      |   |        |   |   |           |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Consolidated
  operating income              |  | $                       | 9,830  |      | $ | 12,550 |   | $ | *) 13,206 |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Depreciation
  and amortization:             |  |                         |        |      |   |        |   |   |           |  
|Software security (DRM)                      |  | $                       | 1,304  |      | $ | 1,176  |   | $ | 1,402     |  
|Enterprise security                          |  |                         | 768    |      |   | 791    |   |   | 889       |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Consolidated
  depreciation and amortization |  | $                       | 2,072  |      | $ | 1,967  |   | $ | 2,291     |  
|                                             |  |                         |        |      |   |        |   |   |           |  

- 40 -

---



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

|          |                                                         |    |                                                                                                                              
|--------- | ------------------------------------------------------- | -- | -----------------------------------------------------------------------------------------------------------------------------
|NOTE 14:- | SEGMENTS OF THE COMPANY AND RELATED INFORMATION (Cont.)
|          |                                                         |    |                                                                                                                              
|          |                                                         | *) | The impact
  of the stock-based compensation expense related to employee stock options in
  the amount of $ 2,253 as follows:

|                                         |  |                                  |       | 
|---------------------------------------- |  | -------------------------------- | ----- | 
|                                         |  | Year ended
  December 31,
  2006 |      
|                                         |  |                                  |       | 
|                                         |  |                                  |       | 
|Software
  security (DRM)                |  | $                                | 1,235 | 
|Enterprise
  security                    |  |                                  | 1,018 | 
|                                         |  |                                  |       | 
|                                         |  |                                  |       | 
|Total
  Stock-based compensation expense |  | $                                | 2,253 | 
|                                         |  |                                  |       | 

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

|                                                 |  |                         |        |      |   |        |  |   |        | 
|------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                                 |  | Year ended December 31, |       
|                                                 |  |                         |       
|                                                 |  | 2004                    |        | 2005 |   | 2006   | 
|                                                 |  |                         |        |      |   |        | 
|Revenues
  from sales to unaffiliated customers: |  |                         |        |      |   |        |  |   |        | 
|Israel                                           |  | $                       | 2,381  |      | $ | 2,927  |  | $ | 4,306  | 
|United States                                    |  |                         | 19,721 |      |   | 26,789 |  |   | 23,426 | 
|Europe (excluding Germany)                       |  |                         | 18,724 |      |   | 21,471 |  |   | 26,725 | 
|Germany                                          |  |                         | 15,384 |      |   | 17,129 |  |   | 19,702 | 
|Japan                                            |  |                         | 9,212  |      |   | 9,345  |  |   | 8,354  | 
|Others                                           |  |                         | 3,699  |      |   | 4,112  |  |   | 6,525  | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|                                                 |  | $                       | 69,121 |      | $ | 81,773 |  | $ | 89,038 | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|Long-lived
  assets:                             |  |                         |        |      |   |        |  |   |        | 
|Israel                                           |  | $                       | 7,200  |      | $ | 7,638  |  | $ | 8,134  | 
|United States                                    |  |                         | 2,632  |      |   | 2,605  |  |   | 2,567  | 
|Germany                                          |  |                         | 263    |      |   | 210    |  |   | 359    | 
|Europe (excluding Germany)                       |  |                         | 2,146  |      |   | 2,048  |  |   | 1,875  | 
|Japan                                            |  |                         | 231    |      |   | 260    |  |   | 239    | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|                                                 |  | $                       | 12,472 |      | $ | 12,761 |  | $ | 13,174 | 
|                                                 |  |                         |        |      |   |        |  |   |        | 

- 41 -

---



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

|          |                                                         |                                                                                             
|--------- | ------------------------------------------------------- | --------------------------------------------------------------------------------------------
|NOTE 14:- | SEGMENTS OF THE COMPANY AND RELATED INFORMATION (Cont.)
|          |                                                        
|          | c.                                                      | Total
  revenues from outside customers are distributed among the following product
  lines:

|            |  |                         |        |      |   |        |  |   |        | 
|----------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|            |  | Year ended December 31, |       
|            |  |                         |       
|            |  | 2004                    |        | 2005 |   | 2006   | 
|            |  |                         |        |      |   |        | 
|            |  |                         |        |      |   |        |  |   |        | 
|HASP tokens |  | $                       | 49,707 |      | $ | 55,969 |  | $ | 60,299 | 
|eSafe       |  |                         | 10,911 |      |   | 11,162 |  |   | 12,166 | 
|eToken      |  |                         | 7,560  |      |   | 14,032 |  |   | 16,316 | 
|Others      |  |                         | 943    |      |   | 610    |  |   | 257    | 
|            |  |                         |        |      |   |        |  |   |        | 
|            |  |                         |        |      |   |        |  |   |        | 
|            |  | $                       | 69,121 |      | $ | 81,773 |  | $ | 89,038 | 
|            |  |                         |        |      |   |        |  |   |        | 

|          |                                        |                         
|--------- | -------------------------------------- | ------------------------
|NOTE 15:- | SELECTED STATEMENTS OF OPERATIONS DATA
|          |                                        |                         
|          | a.                                     | Financial
  income, net:

|                                                         |  |                         |      |      |   |        |   |   |       |  
|-------------------------------------------------------- |  | ----------------------- | ---- | ---- | - | ------ | - | - | ----- | -
|                                                         |  | Year ended December 31, |     
|                                                         |  |                         |     
|                                                         |  | 2004                    |      | 2005 |   | 2006   |  
|                                                         |  |                         |      |      |   |        |  
|Financial
  income:                                      |  |                         |      |      |   |        |   |   |       |  
|Interest on marketable securities                        |  | $                       | 25   |      | $ | 616    |   | $ | 1,384 |  
|Interest                                                 |  |                         | 370  |      |   | 1,244  |   |   | 2,017 |  
|Gain from derivative instruments                         |  |                         |     |      |   | 456    |   |   | 35    |  
|Gain from sale of marketable securities                  |  |                         |     |      |   |       |   |   | 183   |  
|Foreign currency transaction differences                 |  |                         | 140  |      |   |       |   |   |      |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         | 535  |      |   | 2,316  |   |   | 3,619 |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|Financial
  expenses:                                    |  |                         |      |      |   |        |   |   |       |  
|Impairment of available-for-sale marketable
  securities |  |                         |     |      |   | (117   | ) |   |      |  
|Loss from derivative instruments                         |  |                         | (234 | )    |   |       |   |   |      |  
|Foreign currency transaction differences                 |  |                         |     |      |   | (993   | ) |   | (176  | )
|Other                                                    |  |                         | (248 | )    |   | (168   | ) |   | (203  | )
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         | (482 | )    |   | (1,278 | ) |   | (379  | )
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  | $                       | 53   |      | $ | 1,038  |   | $ | 3,240 |  
|                                                         |  |                         |      |      |   |        |   |   |       |  

- 42 -

---



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

|          |                                                |                                                                                              
|--------- | ---------------------------------------------- | ---------------------------------------------------------------------------------------------
|NOTE 15:- | SELECTED STATEMENTS OF OPERATIONS DATA (Cont.)
|          |                                                |                                                                                              
|          | b.                                             | Net earnings
  per share:                                                                    
|          |                                                |                                                                                              
|          |                                                | The following
  table sets forth the computation of basic and diluted net earnings per share:

|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|-- | ----------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|   |                                                                                                                   |  | Year ended December 31, |       
|   |                                                                                                                   |  |                         |       
|   |                                                                                                                   |  | 2004                    |        | 2005 |   | 2006   | 
|   |                                                                                                                   |  |                         |        |      |   |        | 
|1. | Numerator:                                                                                                        |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Net income                                                                                                        |  | $                       | 8,788  |      | $ | 12,356 |  | $ | 14,031 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Numerator for basic and diluted net
  earnings per share                                                          |  | $                       | 8,788  |      | $ | 12,356 |  | $ | 14,031 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|2. | Denominator:                                                                                                      |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Weighted average number of shares                                                                                 |  |                         | 11,940 |      |   | 13,899 |  |   | 14,596 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Denominator for basic net earnings per
  share                                                                    |  |                         | 11,940 |      |   | 13,899 |  |   | 14,596 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Effect of dilutive securities:                                                                                    |  |                         |        |      |   |        |  |   |        | 
|   | Employee stock options                                                                                            |  |                         | 1,060  |      |   | 681    |  |   | 482    | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Dilutive potential Ordinary shares                                                                                |  |                         | 1,060  |      |   | 681    |  |   | 482    | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Denominator for diluted net earnings per
  share - adjusted weighted average shares, assuming exercise of options |  |                         | 13,000 |      |   | 14,580 |  |   | 15,078 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 

|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 16:- | SUBSEQUENT EVENTS (NOT AUDITED)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | In July
  2006, the FASB issued FASB Interpretation 48, Accounting for Income Tax Uncertainties (FIN 48).
  FIN 48 defines the threshold for recognizing the benefits of tax return
  positions in the financial
  statements as more-likely-than-not to be sustained with the taxing
  authority. The recently issued literature also provides guidance on
  derecognition, measurement and classification of income tax uncertainties,
  along with accounting for any related interest and penalties. FIN 48 also
  includes guidance concerning accounting for income tax uncertainties in
  interim periods and increases the level of disclosures associated with any
  recorded income tax uncertainties. FIN 48 is effective for fiscal years
  beginning after December 15, 2006. The differences between the amounts
  recognized in the statements of financial position prior to the adoption of
  FIN 48 and the amounts reported upon adoption will be accounted for as a
  cumulative-effect adjustment recorded to the beginning balance of retained
  earnings.
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | The adoption
  of FIN 48 is expected to have insignificant impact on the Companys
  Consolidated financial statements in the total estimated amount of $ 182.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | On April 1,
  2007, the Companys board of directors authorized the use of our available
  cash for the repurchase of the Companys ordinary shares. According to the
  terms of the buy back program approved by the board, the Company is authorized
  to repurchase its ordinary shares utilizing up to $10 million or to
  repurchase such number of ordinary shares not to exceed 500,000 shares. On
  June 11, 2007, the Companys board of directors increased the extent of the
  buy back program by an additional $10 million. The combined total
  authorization now stands at $20 million. As of June 20, 2007, the Company
  repurchased 464,973 shares utilizing approximately $10 million.                                                                                                                                                                                                                                                                                                                                                                             
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | In April
  2007, The Consortium for Indian Information Technology Education, referred to
  as CIITE, selected the Companys eToken authentication solution to secure its
  vast network of e-Learning resources throughout India and eSafe content
  solution. Over the next three years, the Companys eToken will be provided to
  CIITEs students wishing to access the CIITE Educational Portal.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

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

- 43 -

---