<PAGE>


================================================================================

                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   ----------

                                   FORM 20-F/A

                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                   For the fiscal year ended December 31, 2003
                           Commission File No. 1-8201

                                   ----------

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

                                   ----------

                                     Israel
                 (Jurisdiction of incorporation or organization)

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

                                   ----------

Securities registered or to be registered pursuant to Section 12(b) of the Act:
                                      None

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

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

                                   ----------

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

                           11,477,922 Ordinary Shares

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

                                 Yes [X] No [_]

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

                             Item 17 [_] Item 18 [X]

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                                EXPLANATORY NOTE

This Amended Annual Report on Form 20-F/A (the "Amended 20-F") speaks as of the
filing date of our Form 20-F for the fiscal year ended December 31, 2003, filed
on June 30, 2004 (the "Original 20-F"), except for the certifications and
consents which speak as of their respective dates and the filing date of the
Amended 20-F. Except for changes to Item 5 (other than subsections C, D, E and G
thereof which remain unchanged), Item 11, Item 18 (insofar as it: (a) includes
the UK auditor's report that was inadvertently omitted from the Original 20-F,
and (b) relates to Notes 2, 12, 13 and 16 of our consolidated financial
statements for the year ended December 31, 2003) and Item 19 (insofar as it
relates to the certifications and consents), the Amended 20-F has not been
updated to reflect events occurring subsequent to the filing of the Original
20-F. The Company has amended these sections to conform to the disclosure in
the corresponding sections of the Company's Registration Statement on Form F-3,
as amended and filed with the Commission on March 8, 2005 (File No. 333-121361)
(the "Registration Statement"). The filing of this Amended 20-F shall not be
deemed an admission that the Original 20-F, when filed, included any untrue
statement of a material fact or omitted to state a material fact necessary to
make a statement not misleading.

                                   ----------

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

                                   ----------

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

                                   ----------


                                       2





<PAGE>


                                     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

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

We derived the selected consolidated statements of operations data set forth
below for the years ended December 31, 2001, 2002 and 2003, and the selected
consolidated balance sheet data as of December 31, 2002 and 2003, from our
audited consolidated financial statements, which are included elsewhere in this
annual report. We derived the consolidated statements of operations data for the
years ended December 31, 1999 and 2000 and the selected consolidated balance
sheet data as of December 31, 1999, 2000 and 2001 from audited consolidated
financial statements that are not included in this annual report. Please see
Note 2 to our Consolidated Financial Statements for a discussion of our
significant accounting policies.

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


                                       3





<PAGE>


<TABLE>
<CAPTION>
                                                         December 31,
                                    -------------------------------------------------
                                      2003       2002      2001       2000      1999
                                    --------   -------   --------   -------   -------
                                    (U.S. dollars in thousands, except per share data)
<S>                                  <C>       <C>       <C>        <C>       <C>
Statement of Income Data
Revenues:
   Software security                 $43,521   $40,093   $ 38,421   $38,134   $39,471
   Enterprise security                11,204     9,427      8,192     6,211     5,220
                                     -------   -------   --------   -------   -------
   Total                              54,725    49,520     46,613    44,345    44,691
   Cost of revenues:
   Software security                   7,995     8,054      7,753     9,650     9,251
   Enterprise security                 1,804     2,184      1,567       995       764
                                     -------   -------   --------   -------   -------
   Total                               9,799    10,238      9,320    10,645    10,015
                                     -------   -------   --------   -------   -------
   Gross profit                       44,926    39,282     37,293    33,700    34,676
   Operating expenses:
   Research and
      development                     12,759    12,245     11,043     9,792     7,280
   Selling and marketing              22,012    21,990     22,474    20,752    18,608
   General and administrative          7,745     7,247      8,877     6,657     7,034
   Impairment of
      intangibles assets                  --        --      5,211        --        --
                                     -------   -------   --------   -------   -------
   Total operating expenses           42,516    41,482     47,605    37,201    32,922
                                     -------   -------   --------   -------   -------
   Operating income (loss)             2,410    (2,200)   (10,312)   (3,501)    1,754
   Financial income
      (expenses), net                    480       491       (410)    1,421     1,438
   Other income
      (expenses),net                      (5)     (932)    (3,372)    5,483    10,190
                                     -------   -------   --------   -------   -------
   Income (loss) before
      taxes                            2,885    (2,641)   (14,094)    3,403     13,38
   Taxes on income                        49     2,738       (347)    1,640     4,891
                                     -------   -------   --------   -------   -------
   Income (loss) before
      equity in losses of an
      affiliate                        2,836    (5,379)   (13,747)    1,763     8,491
   Equity in losses of an
      affiliate                         (100)   (1,257)    (1,168)     (323)     (234)
                                     -------   -------   --------   -------   -------
   Net income (loss)                 $ 2,736   $(6,636)  $(14,915)  $ 1,440   $ 8,257
                                     =======   =======   ========   =======   =======
   Net earnings (loss) per share:
      Basic                          $  0.24    ($0.59)    ($1.32)  $  0.13   $  0.73
      Diluted                        $  0.23    ($0.59)    ($1.32)  $  0.12   $  0.72
   Weighted average number of
   shares used in computing net
   earnings (loss) per share:
      Basic                           11,287    11,253     11,275    11,424    11,284
      Diluted                         11,950    11,253     11,275    11,743    11,482
</TABLE>


                                        4





<PAGE>


<TABLE>
<CAPTION>
                                            December 31,
                          -----------------------------------------------
                            2003      2002      2001      2000      1999
                          -------   -------   -------   -------   -------
                                     U.S. dollars in thousands
<S>                       <C>       <C>       <C>       <C>       <C>
Balance Sheet Data:
Cash and cash
equivalents, short term
bank deposits and
marketable securities     $19,516   $15,095   $13,438   $28,519   $34,295
Working capital           $26,625    22,664    24,649    34,519    34,814
Total assets              $55,468    48,539    53,395    73,030    77,277
Total liabilities         $14,512    12,212    10,766    14,334    16,217
Shareholders' equity      $40,956    36,327    42,629    58,696    61,060
</TABLE>

B. CAPITALIZATION AND INDEBTEDNESS

Not applicable.

C. REASONS FOR THE OFFER AND USE OF PROCEEDS

Not applicable.

D. RISK FACTORS

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

Risk Factors Related to our Business

Our present assessments of future economic trends may adversely affect the
accuracy of our earnings projections and guidance disclosed to the public.

From time to time we release earnings projections and disclose guidance to the
public with respect to estimated results of operations. Our current calculations
and predictions with regard to future demand and sales of our products are based
on estimates derived from present assessments of future economic trends and
sales forecasts based on information provided by our existing and potential
customers. Such estimates however, remain uncertain. In the event that the
economic outlook does not improve in accordance with our economic estimates, the
rate of growth of demand for our products may stagnate and consequently, our
sales may not increase and may even decrease. In addition, as it is difficult to
accurately predict economic conditions and trends, we may not accurately gauge
the effect of the general economy on our business. As a result, our actual
results of operations may materially deviate from our earlier projections or may
not react to such changing conditions in a timely manner and this may result in
an adverse impact on our results of operations. Any such adverse deviations from
our earlier guidance due to unforeseen changes in the economy may cause the
price of our ordinary shares to decline.

We face intensive competition in the various industries in which we engage.

We engage in two primary industries: software protection security (or Digital
Rights Management or DRM) and Enterprise Security. Each of these industries is
highly competitive. In the token-based software security market, our primary
direct competitors are Rainbow Technologies, Inc., which was


                                       5





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recently acquired by SafeNet, and WiBu Systems. In addition to these primary
competitors, we face competition from over twenty other software companies. In
the Secure Software Licensing and Distribution Market we provide infrastructure
solutions for electronic software distribution and licensing. Our primary
competitor in this market is Macrovision Corporation. In addition, Digital
River, although being our partner, can also be viewed as a competitor. Since the
DRM industry is competitive, we foresee that we will continue to face
competition from other software developers. Although we believe that the
features and functions of our products are favorably distinguishable from those
of our competitors, we cannot be certain that we will be able to further expand
our market share or that we will be able to maintain our current market share.
Furthermore, we cannot guarantee that we will be successful in our efforts to
develop products with innovative features and functions, or that competitive
pressures will not result in price reductions that could negatively affect our
business in both the token-based software security and the markets for the
manage and sale of software products over the Internet.

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

Furthermore, software developers and operating system vendors such as Microsoft
have added security features to new versions of their operating systems and
software that are designed to limit intrusions by unauthorized users or viruses
and vandals via the Internet. Moreover, Microsoft recently announced that it has
acquired anti-virus technology which will eventually be an integral part of the
Windows operating system. Stronger security, in future Microsoft platforms, may
significantly minimize the vulnerabilities through which virus and vandal
penetration is possible. This, in turn, might lower the need to implement
anti-virus solutions. As the incorporation of such features in future versions
of operating systems and software make these systems less susceptible to outside
penetration, there may be a decrease in the demand for our products. Although we
believe that these solutions are less attractive than our products because they
cannot be upgraded on a timely basis to address new viruses and vandals, we
cannot guarantee that we will be able to convince our current and potential
customers of the benefits of our dedicated anti-virus and anti-vandal solutions.

Within the Enterprise Security industry we also engage in the strong
authentication market. Our main competitors in this area are RSA Security,
SafeNet and Activcard. In addition, many other competitors exist, especially in
the smart card market.

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

We have a recent history of operating losses.

Though we were profitable in 2003, we have a recent history of operating losses.
The revenue and profit potential of three of our products, eSafe, eToken and
Privilege, are unproven, and the revenues from these products are difficult to
predict. In July 2001, we acquired certain assets of Preview Systems


                                       6





<PAGE>


Inc.'s electronic software distribution business, which increased our expenses
and has a history of losses. Any revenues from our acquisition of Preview are
difficult to predict. We believe that the amount of cash and cash equivalents in
our bank account is sufficient to support our current growth plans. We have no
commitments to receive additional financing and due to our recent history of
operating losses, it may be difficult for us to obtain additional financing.

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

Approximately 20.7%, of our revenues in 2003 were generated from sales to our
independent distributors. Although none of our distributors accounted for more
than 10% of our sales in the year ended December 31, 2003, if we lose or
decrease the volume of sales to our distributors, our total sales could
materially decrease. Although we maintain control of the distribution codes for
some of our customers, our relationship with the end-users of our products is
often indirect as we do not directly provide technical support to our end-users,
which may impair our ability to effectively respond to end-users' specific
needs. In addition, we intend to sign additional distribution agreements in the
future, which may make us more dependent on our distributors. There can be no
assurance that our distributors will devote sufficient resources to market and
support our products effectively.

We rely on a limited number of suppliers and subcontractors.

Most of the parts and components that are used to manufacture and assemble our
software protection products are available from several sources, although we do
purchase certain components from single source suppliers. We believe that we
have sufficient inventory of these components to meet our foreseeable needs. If
we are forced to use alternative parts or components, we might have to make
certain changes in the design of products that use such components, which could
result in delays and interruptions in shipments and could adversely affect our
operating results. We use a single subcontractor to manufacture our proprietary
application specific integrated circuits or ASICs. Our Hardlock product also
contains proprietary ASICs, which are supplied by additional single source
suppliers. As of January 2003, the sole manufacturer of our Hardlock line no
longer produces these products. Although we believe we have sufficient stock of
these products in our inventory for the foreseeable future, in the event that we
fail to obtain in a timely manner, one or more alternate subcontractors to
manufacture these products under similar terms as our former manufacturer, such
failure could seriously harm our results of operations.

Some of our production costs are fixed.

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

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

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

     o    unexpected changes in regulatory requirements, tariffs and other trade
          barriers;

     o    difficulties in staffing and managing foreign operations;


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<PAGE>


     o    political instability;

     o    fluctuations in currency exchange rates or restrictions on conversion
          of foreign currencies;

     o    reduced protection for intellectual property rights in some countries;

     o    burdens with complying with a wide variety of foreign laws and
          regulations;

     o    potentially adverse tax consequences; and

In addition, if we fail to obtain approvals, especially with respect to
encryption, from foreign governmental bodies, our sales revenues and results of
operations could be negatively affected.

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

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

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

The markets for our products are characterized by rapid technological change,
evolving industry standards, changes in end-user requirements and sophisticated
hackers constantly improving their methods of stealing end-user technology and
software. Therefore, our future success will depend upon our ability to enhance
our existing products and to develop and introduce products that achieve market
acceptance. In order to meet this challenge, we put a great emphasis on research
and development. These efforts have enabled us to market our products and to
concentrate our development activities to introduce new and enhanced releases of
our products. However, there can be no assurance that we will timely or
successfully complete the development of new or enhanced products or
successfully manage transactions from one product release to the next, or that
our future product will achieve market acceptance.

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

Our success and ability to compete greatly depends on our proprietary
technology. We rely on a combination of patents and trade secrets, copyright and
trademark laws, together with non-disclosure agreements, confidentiality clauses
in our agreements and technical measures to establish and protect proprietary
rights in our products. As of December 31, 2003, we had 18 registered patents
and 34 pending applications in the United States. We also had six registered
patents and 27 pending applications outside of the United States.

To license our products, we primarily rely on "shrink wrap" licenses that are
not signed by the customer and, therefore, we may not be able to enforce our
proprietary rights under the laws of certain jurisdictions. During 1988, we
became aware of the possibility that Aladdin Systems Inc. was



                                       8





<PAGE>


infringing our trademark. We did not, however, file a complaint against Aladdin
Systems Inc. until October 2003, when Aladdin Systems Inc. issued a press
release announcing its release of a new spam-blocking software product under
our trademark. Upon learning of this product, we proceeded to file a complaint
and request for preliminary relief against Aladdin Systems Inc., Aladdin
Enterprise Solutions Inc. and Aladdin Systems Holding, Inc. We have recently
reached a settlement with these companies as well as with Microcomputer
Software, Inc., who recently purchased Aladdin Systems Inc. During the recent
years we have become aware of and are currently investigating the possibility
that one of our former Asian distributors is infringing our intellectual
property. We are currently still investigating this possible infringement
however, should we come to the conclusion that our intellectual property is
being infringed upon, we will take appropriate steps to protect our
intellectual property. Both in this specific case and in general, we cannot
guarantee that we will successfully protect our technology because:

     o    some foreign countries may not protect our proprietary rights as fully
          as do the laws of the United States;

     o    if a competitor were to infringe on our proprietary rights, enforcing
          our rights may be time consuming and costly, diverting both our
          management's attention and our resources;

     o    measures like entering into non-disclosure agreements afford only
          limited protection;

     o    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

     o    our competitors may be able to independently develop products that are
          substantially equivalent or superior to our products or design around
          our intellectual property rights.

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

Significant and protracted litigation may be necessary to protect our
intellectual property rights. The software protection and Internet security
industries are characterized by the existence of a large number of patents and
frequent litigation based on allegations of patent infringement and the
violation of other intellectual property rights. We have not completed an
in-depth exhaustive analysis of such patents or applications. Some of our
competitors have extensive patent portfolios with broad claims. As the number of
competitors in the market grows and the functionality of our products increases,
the possibility of an intellectual property claim against us increases. In
addition, because patent applications can take many years to be published, there
may be a patent application now pending, of which we are unaware, which will
cause us to be infringing when issued in the future.

To address any patent infringement or other intellectual property claims, we may
have to redesign our products to avoid infringement or enter into royalty or
licensing agreements on disadvantageous commercial terms. We may be unable to
successfully redesign our products or obtain a necessary license. We were
recently named as defendants in a patent infringement complaint filed in a U.S.
court and intend to defend ourselves vigorously (see Item 8: "Financial
Information - Legal Proceedings). 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.


                                       9





<PAGE>


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

Software products as complex as those which we offer, may frequently contain
undetected errors or failures, especially when first introduced or when new
versions are released. Despite the extensive product testing which we conduct,
some of our products could contain software errors, defects or viruses, or
otherwise fail to meet customer specifications. Any product defects in our
existing or new products may result in loss or deferral of our revenues,
diversion of our resources, damage to our reputation, or increased service and
other costs. Although we attempt to limit our liability, by including in most of
our end-user license agreements, our distribution agreements and reseller
agreements limitation of liabilities clauses for indirect or incidental damages
arising out of the use of our products, there may be certain jurisdictions which
will not enforce these clauses, thus exposing us to an adverse non-quantifiable
financial risk. As a result, the limitation of liability provisions contained in
these agreements may not be effective.

Our software protection products are vulnerable to piracy.

Like the products of other developers of software security products, our
software security products do not provide absolute protection against piracy.
We, together with our customers, continuously face challenges from computer
hackers, who attempt to neutralize the protection our products provide in order
to enable unlicensed copying of our customers' software. In recent years, we
have faced increasingly serious hacking problems, resulting from the development
by hackers of methods to circumvent some parts of our software protection
products. Such methods are often publicized over the Internet, making them
readily available to those who wish to make unlicensed copies of our customers'
software. We are constantly in the process of developing and releasing solutions
designed to respond to our customers' complaints and handle hacking problems.
Although, to date, we have been successful in developing effective solutions to
these problems, we cannot guarantee that hackers will not continue to develop
methods to contravene the protection provided by our products. Failure to
provide effective software protection solutions could seriously harm our
business.

Our content security product is vulnerable to virus attacks.

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

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

Our Internet content security products, specifically eSafe, are designed to
protect our customers' computer systems and restricted websites from
unauthorized access and from malicious and inappropriate content such as
vandals, viruses and worms. This malicious content can cause irreparable harm to
our customers' computer systems and businesses. Although we believe that
widespread hacking of our products, including eSafe, is not economically
feasible based on commercially available computer equipment, should hackers
manage to bypass our products' security features, affected customers could face
irreparable harm. In addition, our software protection products are used to
protect software from unauthorized use; if our products are ineffective, our
customers may lose substantial revenues due to software piracy. As a result of
damages they incur or lost revenues, customers may bring product liability and
related claims against us. Such claims brought against us, whether valid or not,
could negatively affect our business, operating results and our reputation as
well as divert


                                       10





<PAGE>


management time and resources. Although most of our sales agreements contain
provisions designed to limit our exposure to potential product liability or
related claims, in selling our products, we rely primarily on "shrink wrap"
licenses that are not signed by our customers, which may be unenforceable under
the laws of certain jurisdictions. As a result, the limitation of liability
provisions contained in these agreements may not be effective.

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

We have in the past grown through acquisitions. Our most recent acquisition was
of the assets of Preview Systems Inc.'s electronic software distribution
business. Any future acquisition on our part, could be affected by the process
of integrating any acquired business into our own business and operations, is
risky and may create unforeseen operating difficulties and expenditures. The
areas in which we may face difficulties include:

     o    diversion of our management time after consummation of the acquisition
          from the ongoing development of our businesses, and the release of
          future products and services;

     o    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

     o    the need to integrate new product lines and accounting, management
          information, human resource and other administrative systems to permit
          effective management, and the risk of disorganization if this
          integration is delayed or not implemented.

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

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

As a result of our research and development activities in Israel, we are
required to obtain export permission from the Israeli government before
exporting certain technologies. We have received governmental permission to
manufacture and export the eToken R2 and eToken PRO. We believe that all other
products we currently market do not require such approval. However, we may
require approval to sell certain products that are currently under development,
including encryption technology and future versions of eToken. In addition,
Israeli export regulations are subject to change and updates. We cannot
guarantee that we will be successful in obtaining approvals for new products,
nor be certain of the amount of time it may take to obtain them. Failure to
obtain such approvals in a timely manner could negatively affect our business
and operating results.


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<PAGE>


Risks Related to our Ordinary Shares

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

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

     o    quarter-to-quarter fluctuations in our financial results;

     o    under or over performance against analysts' estimates;

     o    changing laws and government regulations relating to our business;

     o    increased market share penetration by our competitors;

     o    general economic conditions;

     o    increased operating costs, particularly with regard to machinery and
          personnel;

     o    additions or departures of key personnel;

     o    sales of additional ordinary shares;

     o    political, economic or other developments affecting Israel; and

     o    stock market volatility.

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

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

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

Our ordinary shares are currently traded on the NASDAQ National Market. If we
are unable to maintain the requirements for continued listing on the NASDAQ
National Market, our ordinary shares


                                       12





<PAGE>


could be delisted from trading on this market. Consequently, selling (and
buying) our securities would be more difficult because of:

     o    delays in the timing of transactions;

     o    greater difficulty in disposing of securities and obtaining accurate
          quotations; and

     o    possible reduction in security analysts' and the news media's coverage
          of our business.

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

If our ordinary shares were delisted from the NASDAQ National Market, we would
seek to have the ordinary shares traded in the NASDAQ SmallCap Market or another
national securities exchange. However, there is no certainty that we would be
able to obtain an alternative listing for our ordinary shares.

Risks Related to our Operations in Israel

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

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

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

Most of our manufacturing facilities and our corporate headquarters are located
in Israel. Accordingly, security, political and economic conditions in Israel
may directly affect our business, results of operations and financial condition.

Since the establishment of the State of Israel in 1948, a number of armed
conflicts have taken place between Israel and its Arab neighbors, as well as
incidents of civil unrest. In addition, Israel and companies doing business with
Israel have, in the past, been the subject of an economic boycott. Although
Israel has entered into various agreements with Egypt, Jordan and the
Palestinian Authority, there has been an increase in unrest and terrorist
activity which began in September 2000 and which has continued with varying
levels of severity into 2004. Certain parties with whom we do business have
declined to travel to Israel during periods of heightened unrest or tension,
forcing us to make alternative arrangements where necessary. We do not believe
that the political and security situation has had any material impact on our
business to date as a large portion of our business is overseas; however, we can
give no assurance that security and political conditions will have no such
affect in the future. Any hostilities involving Israel or the interruption or
curtailment of trade between Israel and its present trading partners could
adversely affect our operations and could make it more difficult for us to raise
capital. In addition, Israel has recently experienced a wave of unionized
general strikes, in connection with economic reforms being passed into
legislation. Due to the fact that our products are


                                       13





<PAGE>


manufactured in Israel and, for the most part, sold to customers outside of
Israel, a prolonged general strike in which ports are shut down would affect our
ability to deliver our products to our non-Israeli customers. Although, we have
a contingency plan that would allow us to manufacture our products in Germany,
we cannot guarantee that a prolonged general strike would not have a material
adverse effect on our business, results of operations and financial condition.

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

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

Our operations may be affected by negative economic conditions in Israel.

Israel has been going in recent years through a period of recession in economic
activity, resulting in low growth rates and growing unemployment. Our operations
could be adversely affected if the economic conditions in Israel continue to
deteriorate. In addition, due to significant economic measures proposed by the
Israeli Government, there have been several general strikes and work stoppages
in 2003 and 2004, affecting all banks, airports, ports and other essential
services. These strikes have had an adverse effect on the Israeli economy and on
business, including our ability to deliver products to our customers or to
receive raw materials from our suppliers in a timely manner. Following the
passing by the Israeli legislature to implement the economic measures, the
Israeli trade unions have threatened further strikes or work-stoppages, and
these may have a material adverse effect on the Israeli economy and us.

If we are considered to be a passive foreign investment company, either
presently or in the future, U.S. Holders will be subject to adverse U.S. tax
consequences.

We will be a passive foreign investment company, or PFIC, if 75% or more of our
gross income in a taxable year, including our pro rata share of the gross income
of any company, U.S. or foreign, in which we are considered to own, directly or
indirectly, 25% or more of the shares by value, is passive income.
Alternatively, we will be considered to be a PFIC if at least 50% of our assets
in a taxable year, averaged over the year and ordinarily determined based on
fair market value and including our pro rata share of the assets of any company
in which we are considered to own, directly or indirectly, 25% or more of the
shares by value, are held for the production of, or produce, passive income. If
we were to be a PFIC, and a U.S. Holder does not make an election to treat us as
a "qualified electing fund," or QEF, or a "mark to market" election, "excess
distributions" to a U.S. Holder, and any gain recognized by a U.S. Holder on a
disposition or our ordinary shares, would be taxed in an unfavorable way. Among
other consequences, our dividends, to the extent that they constituted excess
distributions, would be taxed at the regular rates applicable to ordinary
income, rather than the 15% maximum rate applicable to certain dividends
received by an individual from a qualified foreign corporation, and certain
"interest" charges may apply. In addition, gain on the sale of our shares would
be treated in the same way as excess distributions. The tests for determining
PFIC status are applied annually and it is difficult to make accurate
predictions of future income and assets, which are relevant to the determination
of PFIC status. In addition, under the applicable statutory and regulatory
provisions, it is unclear whether we would be permitted to use a gross loss from
sales (sales less cost of goods sold) to offset our passive income in the
calculation of gross income. In light of the uncertainties described


                                       14





<PAGE>


above, we have not obtained an opinion of counsel with respect to our PFIC
status and no assurance can be given that we will not be a PFIC in any year. If
we determine that we have become a PFIC, we will then notify our U.S. Holders
and provide them with the information necessary to comply with the QEF rules. A
U.S. Holder who makes a QEF election is taxed currently on such holder's
proportionate share of our earnings. If the IRS determines that we are a PFIC
for a year with respect to which we have determined that we were not a PFIC,
however, it might be too late for a U.S. Holder to make a timely QEF election,
unless the U.S. Holder qualifies under the applicable Treasury regulations to
make a retroactive (late) election. U.S. Holders who hold ordinary shares during
a period when we are a PFIC will be subject to the foregoing rules, even if we
cease to be a PFIC, subject to exceptions for U.S. Holders who made a timely QEF
or mark-to-market election, or certain other elections.

Israeli courts may not enforce judgments rendered outside of Israel.

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

Item 4. Information on the Company

History and Development of the Company

Aladdin Knowledge Systems Ltd. is engaged in Software Security (or Digital
Rights Management, or DRM) and Enterprise Security. Within Software Security,
Aladdin develops and markets the following products: HASP'r' (Hardware Against
Software Piracy), HASP DocSeal, Hardlock'r' and Privilege'TM'. HASP, Hardlock
and DocSeal include both software and hardware components to protect our
customers' software against unauthorized copying and illegal use. By requiring
software users to insert our tokens into their computers before they can use the
protected software, it protects our customers' intellectual property from
unauthorized use. Privilege is a revenue-enabling software security platform
that enables software publishers to distribute secure software via CD, ESD, or
peer-to-peer networks; protect software copyright and intellectual property;
reduce distribution/operational costs; and integrate with in-house or hosted Web
stores and shopping carts. Privilege customers can choose and implement which
path is right for them--lower cost, expanded distribution, and/or new licensing
models.

Within Enterprise Security, Aladdin develops and markets eSafe'r' and
eToken'TM'. eSafe is a gateway-based, integrated content security solution and
service that proactively protects networks against viruses, worms, spam and
non-productive content; enables real-time inspection of Internet traffic without
reducing network performance; reduces the risk of security exploits, P2P, IM and
blended threats; and enables lower total cost of ownership with an integrated,
modular design.

eToken is a USB based smart card device, the size of a house key, for
cost-effective strong authentication and ecommerce that provides enhanced
network/application security and ensures safe information access by authorized
users; improved and cost-effective password and ID management; and secure
mobility of digital credentials/certificates and keys. The eToken product line
is composed of


                                       15





<PAGE>


eToken R2, eToken Pro, and eToken Enterprise. A Software Developers Kit is
available for creating custom eToken applications.

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

Capital Expenditures

During the past three years, our capital expenditures amounted to approximately
$3.3 million. The focus of our capital expenditure program primarily included
investment in back-office IT systems, equipment for research and development and
testing purposes, general computer software and hardware, investment in
additional financial modules for our global ERP and leasehold improvement in our
offices.

B. BUSINESS OVERVIEW

Our Products

Software DRM (Digital Rights Management)

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

o    end-users making unauthorized copies of software at work or at home;

o    retailers selling illegal copies;

o    computer dealers loading illegal copies onto their customers' hardware;

o    bulletin board operators and subscribers offering software for illegal
     copying;

o    commercial counterfeiters offering illegally copied software for sale; and

o    companies exceeding the number of users authorized by network licenses.

According to the eighth annual independent study on global software piracy
commissioned by the Business Software Alliance in June 2003, the global software
industry's losses due to the illegal use and duplication of business software
reached $13.08 billion in year 2002. North America, Asia, and Western Europe
accounted for the vast majority (84%) of revenue losses as these regions are the
predominant users of software. The countries with the highest dollar losses due
to software piracy, in descending order, were China, the United States, Japan,
Germany, France and Italy. The total revenue loss for these countries was $8.0
billion or 60% of the worldwide losses in the year 2002.

Due to the risk of substantial loss of revenue as a result of software piracy,
software developers have a need to protect their software against unauthorized
use. However, developers of low cost, "shrink


                                       16





<PAGE>


wrap" software generally do not find the use of sophisticated mechanisms to
protect their software cost-effective. Most users of sophisticated protection
products today are software developers that sell products at relatively higher
price levels, typically in excess of $250 per unit. These software developers
range from smaller operations developing applications for specific vertical
markets, to large software developers creating sophisticated enterprise-wide
applications for distributed systems.

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

Token-Based Security Software Solutions

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

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

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

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

     o    Enhanced Security. The proprietary designs of both the hardware and
          software components of our systems provide enhanced security against
          unauthorized use of software. The ASIC in each token is custom-coded
          to prevent reverse engineering. In addition, the proprietary
          algorithms and anti-debugging features in our software are designed to
          ensure that the link between the token and the developer's software is
          secure.


                                       17





<PAGE>


     o    Transparency. Once connected, our hardware keys are transparent to the
          computer user and do not interfere with the operation or use of the
          computer or other peripheral products.

     o    Compatibility. Our security products are available with interfaces for
          hundreds of languages and compilers under DOS, OS/2, Windows NT/2000,
          Windows 95/98/ME, Windows XP, Mac OS 8.6-9.x, Mac OS X, Linux, local
          area networks and other operating systems, as well as open systems
          such as Sun, HP and others. Our products offer solutions for all
          standard hardware platforms, including IBM PCs and PS/2s and their
          compatibles, Macintosh, Power Macintosh, Japanese NEC Computers and
          Unix workstations.

     o    Ease of Use. Our products are easy and convenient to use, and provide
          a low-cost solution to the problems of software piracy and illegal
          use. Our products can also be used to control access to different
          software modules and different software packages, and to limit usage
          to authorized users.

     o    Multilevel licensing concepts. Our products incorporate Full
          Authorization and Remote Update Systems that enable the user to
          protect multiple applications with a single key. They enable the user
          to specify the limitations of the use of each application, specific
          modules, the number of activations, the expiration date and the number
          of sites activated and update these limitations remotely in a secure
          manner.

We currently offer two lines of token-based software security systems: HASP and
Hardlock In the past, we also used to offer MicroGuard.

HASP Product Line

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

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


                                       18





<PAGE>


<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
HASP Product        Functionality                          Port
--------------------------------------------------------------------------------
<S>                 <C>                                    <C>
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
HASP4 Std           o    Copy protection                   USB, Parallel

                    o    1 perpetual license

                    o    Cross platform - supports
                         numerous operating systems
                         (Windows, Macintosh, Linux)
--------------------------------------------------------------------------------
HASP4 M1            o    Copy protection,                  USB, Parallel

                    o    Licensing - can store up to 16
                         licenses on one token

                    o    112 bytes memory

                    o    Supports components licensing -
                         enables licensing of several
                         components, modules or
                         applications on one token

                    o    Demo licensing - enables
                         creation of demo versions of
                         applications protected with
                         the token

                    o    Pay-per-use

                    o    Cross platform (Windows,
                         Macintosh, Linux)
--------------------------------------------------------------------------------
</TABLE>


                                       19





<PAGE>


<TABLE>
--------------------------------------------------------------------------------
<S>                 <C>                                    <C>
HASP4 M4            o    Copy protection                   USB, Parallel, PCMCIA

                    o    Licensing - can store up to 112
                         licenses on one token

                    o    496 bytes memory

                    o    Supports components licensing

                    o    Demo licensing

                    o    Pay-per-use

                    o    Cross platform (Windows,
                         Macintosh, Linux)
--------------------------------------------------------------------------------
HASP4 Time          o    Copy protection                   USB, Parallel

                    o    Licensing - can store up to 8
                         licenses

                    o    512 bytes memory

                    o    Supports rental and
                         subscription licensing

                    o    Cross platform (Windows,
                         Macintosh, Linux)
--------------------------------------------------------------------------------
HASP4 Net           o    Copy protection                   USB, Parallel

                    o    Licensing - can store up to 112
                         licenses

                    o    496 bytes memory

                    o    Supports floating licenses -
                         enables concurrent users of
                         license in network environment
                         and manages how many users can
                         simultaneously run application

                    o    Components licensing

                    o    Demo licensing

                    o    Pay-per-use

                    o    Cross platform (Windows,
                         Macintosh, Linux)
--------------------------------------------------------------------------------
</TABLE>


                                       20





<PAGE>


Hardlock Product Line

The following chart sets forth information regarding our principal Hardlock
products, which support Windows 95/98/ME/2000/XP and Linux and use an on-chip
encryption engine based on a proprietary algorithm:

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
HASP Product        Functionality                          Port
--------------------------------------------------------------------------------
<S>                 <C>                                    <C>
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
Hardlock Eye Std    o    Copy protection                   Parallel
--------------------------------------------------------------------------------
Hardlock Eye Mem    o    Copy protection                   Parallel

                    o    Licensing

                    o    128 byte memory
--------------------------------------------------------------------------------
Hardlock Twin       o    Copy protection                   Parallel and Serial

                    o    Licensing

                    o    Combined parallel and serial
                         connector in a single token

                    o    128 byte memory
-------------------------------------------------------------------------------
Hardlock USB        o    Copy protection                   USB

                    o    Licensing

                    o    128 byte memory
--------------------------------------------------------------------------------
Hardlock PCMCIA     o    Copy protection                   PCMCIA

                    o    Licensing.
--------------------------------------------------------------------------------
Hardlock Server     o    Copy protection                   Parallel, USB

                    o    Floating licensing

                    o    128 byte memory
--------------------------------------------------------------------------------
Hardlock Internal   o    Copy protection                   A card that connects
                                                           internally to the PC
                    o    Licensing

                    o    128 byte memory
--------------------------------------------------------------------------------
</TABLE>

Microguard Product Line

In the past, we sold an additional product line, MicroGuard, however the sales
from this product line have become negligible.


                                       21





<PAGE>


Secure Software Licensing and Distribution Products

Privilege Software Commerce Platform

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

Privilege is composed of three principle components:

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

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

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

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

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

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

     o    manage the full product lifecycle, from product development through
          end-customer usage rights; and

     o    trial-enable software, including electronically enabled
          try-before-you-buy models.

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

Enterprise Security

Content Security Products

Today's anti-virus software products are able to cope with all existing and
known viruses and virus technologies. The penetration and success of the
Internet and its innovative active content technologies such as Java, ActiveX
and HTML scripts have created a new type of Internet-specific threat
collectively called malicious content or Vandals. In addition, numerous security
holes discovered in various Internet enabled applications and even in Microsoft
Windows operating systems, were immediately exploited by Vandals in order to
penetrate and infect organizations. Unfortunately, existing anti-virus software
products are not designed to deal with these new threats. Since vandals use


                                       22





<PAGE>


the Internet to travel from one infected computer to the other, they are
effectively able to get into such computers before reactive signature-based
security and anti-virus solutions receive an update and are able to block them.

Signature-based anti-virus software has been widely used since 1990 and today
more than 90% of corporate users have some sort of anti-virus protection
deployed throughout their organization. However, anti-virus software operates by
scanning files and trying to detect the signature of viruses from the database
of known viruses and relies heavily on the anti-virus vendor that must continue
to update the database in a timely manner in order to be protected against the
new viruses. In the Internet age, one cannot afford to be merely defensive and
risk becoming the first victim to be hit. Proactive solutions that provide
real-time protection against unknown potential threats by enforcing content
security policies at the gateway level are therefore critical.

eSafe Family of Products

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

     o    The Integrated gateway and mail solution - eSafe Gateway

     o    The Internet gateway solution - eSafe Web

     o    The Corporate eMail server solution - eSafe Mail

     eSafe Gateway

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

The following are eSafe Gateway's unique features:

     o    NitroInspection patent-pending technology for fast on-line transparent
          inspection without overhead or delay on web browsing and file download
          traffic;

     o    Selective removal of cookies, JavaScript, VBScript, macros, and
          specific file types;

     o    ICSA and Check Mark Certified anti-virus protection, with unique
          proactive Macro Terminator and Ghost Machine technologies;

     o    Scalable architecture with a built-in cluster for load sharing and
          fail-over;

     o    Real-time protection from all types of malicious code including
          viruses, vandals, Trojans, ActiveX, Java, worms and scripts; and

     o    Eliminates malicious code embedded inside HTML web pages.

     o    Blocks traffic generated by unauthorized applications, such as P2P
          clients, Instant Messengers, Adware/Spyware and more.

     eSafe Mail

eSafe Mail is a subset of eSafe Gateway that provides proactive content security
for e-mail only (SMTP). In addition, we sell an add-on module of Advanced Anti
Spam to our eSafe Mail product.

     eSafe Web


                                       23





<PAGE>


eSafe Web is a subset of eSafe Gateway, that provides proactive content security
for browsing (HTTP) and file downloading (FTP).

eSafe's Unique technologies

     Virtual Appliance'TM'

The Virtual Appliance concept is the industry's first content security and
anti-virus gateway and mail inspection product that is delivered as a CD image,
pre-loaded with a hardened Linux OS and eSafe content security applications. It
can be easily installed on any hardware of customers' choice, thus turning it
instantly into a security appliance.

     MacroTerminator'TM'

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

     GhostMachine'TM'

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

     SmartScript'TM' Filtering

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

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

     XploitStopper'TM'

The virus and Internet worm outbreaks in the last three years (Kaza, Nimda,
Sircam, BugBear, etc.) were able to cause worldwide damage that is estimated at
billions of US Dollars by industry experts. All those outbreaks were caused
because viruses and worms were able to exploit existing security holes in
various Internet applications (Outlook, IIS, etc.). eSafe's new and innovative
XploitStopper(TM) technology is designed to look for known security holes that
can be exploited by malicious code and


                                       24





<PAGE>


block them before the virus is able to enter the organization. This unique
approach minimizes the threat from new and unknown viruses and Internet worms.

     NitroInspection'TM'

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

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

Anti-Spam

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

Strong Authentication Products

     eToken Family of Products

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

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


                                       25





<PAGE>


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

International Data Corporation predicts that USB tokens and smartcards will
become interoperable because USB tokens also have PKI (Public Key
Infrastructure) and digital-certificate capability. As the technology develops,
USB keys will be able to provide an integrated solution that could only
previously have been provided through separate authentication devices. We are
currently developing expanded functionality for the eToken in order to simplify
password management by allowing the eToken to store multiple log-on credentials,
such as different passwords, which can then be automatically entered into the
application without needing the user to remember or manually type it in.

In the first quarter of 2004 we entered into an agreement with VeriSign, Inc.,
according to which, VeriSign will use our eToken(TM) NG with One-Time Password
(OTP) functionality for its strong authentication service beta program, which
began testing in April 2004.

Marketing and Promotion

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

     o    press releases;

     o    direct mail campaigns;

     o    e-mail sponsorships and campaigns;

     o    publication of technical and educational articles in industry
          journals;

     o    participation in industry trade shows and partner events;

     o    organization of and participation in product/technology conferences
          and seminars;

     o    competitive analysis;

     o    sales training;

     o    advertising in trade magazines;

     o    Internet promotion;

     o    Internet advertising;

     o    development and distribution of literature about our company; and

     o    maintenance of our web site

We sell our products directly through subsidiaries, value-added resellers,
original equipment manufacturers and through independent distributors in over 50
countries worldwide. We believe that our success and ability to market our
products will depend, to a significant degree, on our subsidiaries and
independent distributors and resellers. In the years ended December 31, 2003,
2002, and 2001, approximately 20.7%, 22.6% and 19.4%, respectively, of our
consolidated revenues were generated from sales to our independent distributors.
During these periods, no single distributor accounted for more than 10% of our
sales. We generally have short-term written agreements with our distributors and
resellers, all of which are non-exclusive.


                                       26





<PAGE>


In 2001, we entered into distribution agreements with leading distributors in
Europe (Articon-Integralis) and the United States (Westcon Group). We have
continued our relationship with these distributors in 2002 and into 2003. The
Alasso unit of Articon-Integralis was recently sold by Articon-Integralis to
InTechnology plc and we have maintained our relationship with Alasso. We have
also entered into an agreement with Digital River, Inc., which allows us to
offer our products and services to their customers at our standard rates. We
intend to continue to target resellers and system integrators that focus on
providing security solutions to enterprises. In addition, we launched in 2001
Aladdin Security Alliance, our solution partner program. In this program we
present joint solutions that are offered to the market by both our partners and
our distribution channels. These distribution channels include vendors in areas
such as PKI, VPN (Virtual Private Network), Access Control, Web Access, PC
Security and more.

Maintenance and Support

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

     HASP and Hardlock - Token-Based Security Software Solutions

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

     Privilege - Secure Software Licensing and Distribution Products

The license agreement for Privilege SCP includes a maintenance and support
component. The standard maintenance and support package provides free access to
product updates along with access to our support centers worldwide, during set
hours. The support centers are accessible to our customers via e-mail or
telephone.

Managed Privilege is our managed service which hosts the software publisher's
store. Our Managed Privilege customers receive two levels of support. The first
level includes free access to product updates along with access to our support
centers. The second level includes various management and administrative options
to ensure Web site availability, prepare products for distribution, and track
the success of product promotions.

     eSafe - Content Security Products

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


                                       27





<PAGE>


These maintenance agreements include the same services provided during the
warranty period. The maintenance agreements generally have one-year terms and in
some cases are automatically renewable.

     eToken - Enterprise Security Products

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

Government Controls

As a result of our research and development activities in Israel, we are
required to obtain export permission from the Israeli government before
exporting certain technologies. We have governmental permission to manufacture
and export the eToken R2, and eToken PRO, and we have renewed the governmental
permission to manufacture and export eToken R2, and eToken PRO, including the
most up to date releases of these products. In addition we have recently
received governmental permission to manufacture and export eToken NG / PRO. We
believe that all of the other products that we currently market do not require
such approval. However, we may require approval to sell certain products
currently under development that include encryption technology as well as future
versions of eToken.

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

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

Customers

We sell our software security products primarily to software developers and
distributors. No one customer accounted for more than 10% of our net sales in
2003, 2002 and 2001. The following is a breakdown of our sales by geographic
market:

<TABLE>
<CAPTION>
                                 Percentage of sales in,
               ----------------------------------------------------------
Year             Europe
ending         (excluding            Southeast   United
December 31,    Germany)    Israel      Asia     States   Germany   Other
------------   ----------   ------   ---------   ------   -------   -----
<S>               <C>        <C>       <C>        <C>      <C>       <C>
2003              25.3%      3.7%      14.4%      32.2%    22.1%     2.3%
</TABLE>


                                        28





<PAGE>


<TABLE>
<S>               <C>        <C>       <C>        <C>      <C>       <C>
2002              26.8%      3.9%      12.6%      35.3%    18.7%     2.7%

2001              26.9%      5.2%      12.3%      32.4%    20.9%     2.3%
</TABLE>

Manufacturing, Testing and Suppliers

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

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

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

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

We have implemented a contingency plan to support the ability to produce and
supply goods to our customers in the event that one of our sites is shut down.
The contingency plan covers physical production and software recovery. It has
been tested and is operative. The safety stock which is held by our subsidiaries
is part of our contingency plan.

C. ORGANIZATIONAL STRUCTURE

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


                                       29





<PAGE>


In addition we have a wholly owned holding company, Hafalad BV, which is
incorporated in Holland. Through Hafalad we wholly own Aladdin Western Europe BV
(formerly known as Aladdin Knowledge Systems BV), Aladdin Western Europe
(Aladdin France S.A.R.L.) (formerly known as Aladdin France S.A) and Aladdin
Knowledge Systems Deutschland GmbH incorporated in Germany. Aladdin Western
Europe BV is incorporated in Holland and Aladdin Western Europe (Aladdin France
S.A.R.L.) is incorporated in France. We have finalized the process of
reorganizing the management of activities in France, the Netherlands and the
United Kingdom, under the single management of Aladdin Western Europe Ltd. In
addition to engaging in distribution, support and management, our German
subsidiary and Portland, Oregon office provide research and development
services, however we have nearly finalized the process of closing our Portland,
Oregon office and have transferred the research and development operations
conducted in our Portland office to Tel Aviv. In addition, we have recently
established Aladdin Asia Limited, a Hong Kong based subsidiary owned by us and
by Hafalad BV.

D. PROPERTY, PLANTS AND EQUIPMENT

Our executive, research and development offices and certain of our production
facilities are located in Tel Aviv, Israel. We currently lease a total of
approximately 2,300 square meters of space from an unaffiliated entity, at an
aggregate base monthly rent of approximately $17,500, which lease expires in
2006 with an option for one additional year.

Most of our production facilities are located in Kiryat Gat, Israel. We
currently lease a total of approximately 976 square meters in Kiryat Gat, which
lease expires on September 30, 2005, for an aggregate monthly rent of
approximately $6,300. In addition, we lease approximately 725 square meters in
Haifa, Israel, where our Internet security research and development activities
are headquartered, at a monthly rent of approximately $5,500. Our lease in Haifa
expires on February 29, 2005.

We lease space for our operations in the United States, Germany, United Kingdom,
Japan, the Netherlands and France. Aggregate monthly lease payments under these
leases are approximately $97,000. Our leases in these locations expire between
2004 and 2007.

Our aggregate lease expenses (including motor vehicles) for the years 2003, 2002
and 2001 were $2,570,000, $2,514,000 and $2,423,000, respectively. We believe
that our facilities are adequate for our current needs. In the event that
additional facilities are required, we believe that we could obtain such
additional facilities at commercially reasonable prices.


                                       30





<PAGE>


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 annual 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
e-mail-borne content, including spam and viruses. Our software DRM products
allow software publishers to limit revenue loss from software theft and piracy.
Our enterprise security solutions enable organizations to secure their
information technology assets by controlling who has access to their networks
(authentication) and what content their users can utilize (content security).

We were established in 1985 with our principal focus on software protection
through our HASP product line. Between 1996 and 2003, we completed five
acquisitions of businesses and product lines which broadened our product
offering and enhanced our research and development, direct marketing and selling
capabilities. We acquired our eSafe product line at the end of 1998. In 1999, we
entered the enterprise security market by complementing eSafe with our eToken
product line. As a result of the additional expenses incurred in this
transition, as well as generally adverse economic conditions, we incurred net
losses in 2001 and 2002. In 2003, we returned to profitability. In 2003, we
generated 80% of our revenues from our software DRM products and the balance
from our enterprise security products.

Revenues

We generate revenues from two sources: sales of hardware products and software
license fees. To date, we have derived the substantial majority of our revenues
from sales of hardware products.

In 2003, part of our revenues was denominated in Euros, Japanese Yen and British
pounds, all of which have significantly appreciated versus the U.S. dollar
during the year. When translating these revenues into U.S. dollars for the
purposes of preparing our consolidated financial statements, one of the effects
of this appreciation was to increase our reported revenues. 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 the
"--Quantitative and Qualitative Disclosures About Market Risk--Foreign exchange
risk" in Item 11 of this annual report for disclosure of the effect of changes
in exchange rates on our overall revenues, gross profit and income (loss) from
operations for the years ended December 31, 2001, 2002 and 2003.

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.


                                       31





<PAGE>


License fees. 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 filters and application filtering. In both cases, 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.
We determine the fair value of the maintenance and support component, which
includes the right to periodic updates when and if available, based on the price
charged by us for such maintenance and support when provided separately.
Maintenance and support revenue is deferred and recognized on a straight-line
basis over the term of the maintenance and support agreement, which is typically
one year.

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

Our deferred revenues as of December 31, 2002 were $2.3 million and as of
December 31, 2003 were $3.4 million. This 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 5% of our revenues.

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

<TABLE>
<CAPTION>
                                 Year ended
                                December 31,
                             ------------------
                             2001   2002   2003
                             ----   ----   ----
<S>                           <C>    <C>    <C>
United States                 32%    35%    32%

Europe (excluding Germany)    27     27     25
Germany                       21     19     22
Japan                          9      9     13
Israel                         5      4      4
Others                         6      6      4
</TABLE>

Repeat customers. We consider the proportion of our revenues from repeat
customers to be an important tool in analyzing our software DRM sales. We
believe that a significant portion of our revenues in 2003 were 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


                                       32





<PAGE>


components, manufacturing costs (including costs of subcontractors), salaries
and related personnel expenses for employees engaged in the manufacture and
support of our products, and an allocation of overhead and facilities costs.

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

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

Operating expenses

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

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

Financial income, net. Financial income, net, consists primarily of interest
earned on bank deposits net of bank charges, impairment of our investments in
marketable securities, and foreign currency reimbursement gains resulting from
the conversion of monetary balance sheet items denominated in non-U.S. dollar
currencies.

Taxes on income. Although Israeli companies generally are subject to income tax
at the corporate rate of 36% in 2003, we benefit from Israeli government tax
exemption programs that reduce our effective tax rate as described under the
caption "--Corporate Tax."

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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


                                       33





<PAGE>


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, 2003, our allowance for doubtful accounts was
$972,000 and our trade receivables were $9.8 million. To date, our allowances
for doubtful accounts have been sufficient.

Inventories

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

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 $1.6 million as of December 31,
2003. Deferred tax assets, related valuation allowances and deferred tax
liabilities are determined separately by tax jurisdiction. We believe sufficient
uncertainty exists regarding our ability to realize our deferred tax assets in
certain foreign jurisdictions and, accordingly, a valuation allowance has been
established against the deferred tax assets in those jurisdictions. We believe
that it is more likely than not that the results of future operations will
generate sufficient taxable income to utilize the remaining deferred tax assets,
net of valuation allowances. While we have considered future taxable income and
ongoing tax planning strategies in assessing the need for any valuation
allowance, in the event we were to determine that we will be able to realize our
deferred tax assets in the future in excess of the net recorded amount, an
adjustment to the valuation allowance would increase income in the period such a
determination is made. Likewise, should we determine that we would not be able
to realize all or part of our net deferred tax assets in the future, an
adjustment to the valuation allowance would be charged to income in the period
such a determination is made. Our effective tax rate is directly affected by the
relative proportions of domestic and international revenue and income before
taxes, as well as the estimated level of annual pre-tax income. We are also
subject to changing tax laws in the multiple jurisdictions in which we operate.

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

Goodwill

Under Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets"


                                       34





<PAGE>


("SFAS No. 142"), goodwill acquired in a business combination that closes on or
after July 1, 2001 is deemed to have indefinite life and will not be amortized.
SFAS No. 142 requires goodwill to be tested for impairment on adoption and at
least annually thereafter or between annual tests in certain circumstances, and
written down when impaired, rather than being amortized as previous accounting
standards required. Goodwill is tested for impairment by comparing the fair
value of the reporting unit with its carrying value. Fair value is determined
using the income approach. Significant estimates used in the methodologies
included estimates of future cash flows and estimates of discount rates. We have
performed impairment tests on our goodwill and as of December 31, 2003, no
impairment losses have been identified. As of December 31, 2003, we had total
goodwill of $7.3 million on our balance sheet. In assessing the recoverability
of our goodwill and other intangible assets, we must make assumptions regarding
the estimated future cash flows and other factors to determine the fair value of
the respective assets. If these estimates or their related assumptions change in
the future, we may be required to record impairment charges for these assets.

Impairment of long-lived assets

Under Statement of Financial Accounting Standard No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," long-lived assets, such as
property and equipment, and purchased intangibles subject to amortization, are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying 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 2002 and 2003, no impairment charges were recorded for
long-lived assets.

Investment in other companies

We have investments in two related investment funds managed by Tamir Fishman
Ventures Management II Ltd. The investment is stated at cost since we do not
have the ability to exercise significant influence over operating and financial
policies of the investee. Our management reviews our investment for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an investment may not be recoverable. In 2002, we realized an impairment charge
of $1.0 million related to these investments and we may realize additional
impairment charges in the future.

Litigation

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


                                       35





<PAGE>


A. RESULTS OF OPERATIONS

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

<TABLE>
<CAPTION>
                                                               Year ended
                                                             December 31,
                                                        -----------------------
                                                         2001     2002     2003
                                                        -----    -----    -----
<S>                                                     <C>      <C>      <C>
Revenues :
Software security                                        82.4%    81.0%    79.5%
Enterprise security                                      17.6     19.0     20.5

Total revenues                                          100.0    100.0    100.0
Cost of revenues:
Software security                                        16.6     17.0     14.6
Enterprise security                                       3.4      3.7      3.3

Total cost of revenues                                   20.0     20.7     17.9

Gross profit                                             80.0     79.3     82.1
Operating expenses:
Research and development                                 23.7     24.7     23.3
Selling and marketing                                    48.2     44.4     40.2
General and administrative                               19.0     14.6     14.2
Impairment of intangible assets                          11.2       --       --

Total operating expenses                                102.1     83.7     77.7

Operating income (loss)                                 (22.1)    (4.4)     4.4
Financial income (expenses), net                         (0.9)     1.0      0.9
Other expenses, net                                      (7.2)    (1.9)     0.0

Income (loss) before taxes on income                    (30.2)    (5.3)     5.3
Taxes (benefit) on income                                (0.7)     5.6      0.1

Income (loss) before equity in losses of an affiliate   (29.5)   (10.9)     5.2
Equity in losses of an affiliate                         (2.5)    (2.5)    (0.2)

Net income (loss)                                       (32.0)%  (13.4)%    5.0%
</TABLE>

Year ended December 31, 2003 compared to year ended December 31, 2002

Revenues

Total revenues increased by 10.5% to $54.7 million in 2003 from $49.5 million in
2002. Currency fluctuations accounted for $2.5 million of this increase.

Software DRM. Revenues from software DRM increased by 8.6% to $43.5 million in
2003 from $40.1 million in 2002. This increase was attributable to an increase
of $3.8 million in the sales of our HASP products in all geographic markets.
This increase was comprised of $1.8 million in additional revenues resulting
from an increase of 12.2% in the number of HASP family keys sold in 2003
compared to 2002 and an increase of $2.0 million as a result of currency
fluctuations.


                                       36





<PAGE>


Enterprise security. Revenues from enterprise security increased by 18.9% to
$11.2 million in 2003 from $9.4 million in 2002. This increase was primarily
attributable to growth of $1.3 million in sales of eToken, as well as an
increase of $500,000 as a result of currency fluctuations. The increase in
eToken sales resulted from an increase of 46.9% in the number of eToken family
keys sold in 2003 compared to 2002.

Cost of revenues

Total cost of revenues decreased by 4.3% to $9.8 million in 2003 from $10.2
million in 2002. Currency fluctuations accounted for a $169,000 increase in
costs.

Software DRM. Cost of revenues from software DRM decreased by 4.9% to $8.0
million in 2003 from $8.4 million in 2002 as a result of a decrease in
depreciation expenses related to production equipment, which we do not expect to
have a recurring effect in future periods. Cost of revenues as a percentage of
revenues decreased to 18.4% in 2003 compared to 21.0% in 2002. This decrease was
primarily attributable to the decrease in depreciation expenses in the amount of
$727,000 in 2003 compared to 2002 As a result, the gross margin for software DRM
increased to 81.6% in 2003 from 79.0% in 2002.

Enterprise security. Cost of revenues for enterprise security remained constant
in 2003 and totaled $1.8 million. Gross margin for enterprise security increased
to 83.9% in 2003 from 80.6% in 2002.

Gross profit increased by 14.4% to $44.9 million in 2003 from $39.3 million in
2002. Cost of revenues as a percentage of revenues decreased to 16.1% in 2003
compared to 19.4% in 2002. This decrease was primarily attributable to stable
fixed costs of production. These fixed costs as a percentage of revenues
deecreased by 2.1% in 2003 compared to 2002. As a result, gross margin increased
to 82.1% in 2003 from 79.3% in 2002.

Research and development

Research and development expenses increased by 4.2% to $12.8 million in 2003
from $12.2 million in 2002, primarily as a result of the expansion of our
research and development activities. As a result of these relatively stable
costs and the increase in revenues in 2003 compared to 2002, research and
development expenses as a percentage of revenues decreased to 23.3% in 2003 from
24.7% in 2002. Currency fluctuations accounted for $358,000 of the total
increase in research and development expenses during this period.

Selling and marketing

Selling and marketing expenses remained essentially the same in 2003 compared to
2002 and totaled $22.0 million. The stability in selling and marketing expenses
was attributable to an increase in sales commissions in the amount of $410,000
due to the growth in our revenues in 2003, which was offset by a decrease of
$313,000 in employment costs due to consolidation of our selling and marketing
efforts in Europe. As a percentage of revenues, selling and marketing expenses
decreased to 40.2% in 2003 from 44.4% in 2002.

General and administrative

General and administrative expenses increased by 6.9% to $7.7 million in 2003
from $7.2 million in 2002. This increase was primarily attributable to an
increase in legal fees due to legal proceedings that we were involved in either
as a plaintiff or defendant. As a percentage of revenues, general and


                                       37





<PAGE>


administrative expenses decreased to 14.2% in 2003 from 14.6% in 2002. Currency
fluctuations accounted for $130,000 of the total increase in general and
administrative expenses during this period.

Financial income (expenses), net

Financial income, net, decreased by 2.2% to $480,000 in 2003 from $491,000 in
2002. This decrease was primarily attributable to the decrease in our financial
income related to foreign currency reimbursement gains in the amount of
$289,000, partially offset by a decrease in financial expenses due to an
impairment of available-for-sale marketable securities in the amount of $391,000
that occurred only in 2002.

Other expenses, net

Other expenses, net, were $5,000 in 2003 compared to $932,000 in 2002. Other
expenses, net in 2002 were primarily due to an impairment write-down of $1.0
million of our investment in one of the two investment funds managed by Tamir
Fishman Ventures Management II Ltd. as a result of significant uncertainty over
the future realization of its investment portfolio.

Taxes (benefit) on income

Taxes on income were $49,000 in 2003 compared to $2.7 million in 2002. Taxes on
income in 2003 were primarily due to income taxes from ongoing operations of
approximately $399,000, and were partially offset by deferred tax income of
$350,000 relating to carry-forward tax losses. Taxes on income in 2002 were
primarily due to income taxes from ongoing operations of approximately $238,000
and due to an increase of the valuation allowance for deferred tax assets of
approximately $2.5 million. As of December 31, 2001 we believed that it was more
likely than not that the remaining net deferred tax assets of approximately $3.4
million related to our German subsidiary would be realized, principally based
upon its strong earning history and forecasted taxable income. In 2002, several
developments were considered in determining the need for an increase in the
valuation allowance, including a market decline in Germany, increasing
uncertainty and a decrease of visibility in the market as a whole, a significant
decrease in sequential quarterly revenue levels and the failure to achieve our
forecasted results in Germany for 2002. As a result of our assessment, we
increased the valuation allowance on the deferred tax asset in the German
subsidiary in the amount of approximately $2.5 million.

Year ended December 31, 2002 compared to year ended December 31, 2001

Revenues

Total revenues increased by 6.2% to $49.5 million in 2002 from $46.6 million in
2001.

Software DRM. Revenues from software DRM increased by 4.4% to $40.1 million in
2002 from $38.4 million in 2001. This increase resulted primarily from the
acquisition of Preview Systems Inc. which was consummated in July 2001 and
generated revenues for only part of 2001 compared to the full year in 2002.

Enterprise security. Revenues from enterprise security increased by 15.1% to
$9.4 million in 2002 from $8.2 million in 2001. This increase resulted primarily
from an increase of $1.3 million in sales of eToken products. This increase was
attributable to an increase of $560,000 as a result of an increase in the
average selling price per unit, and an increase of $740,000 as a result of an
increase in the number


                                       38





<PAGE>


of eToken keys sold in 2002 compared to 2001.

Cost of revenues

Total cost of revenues increased by 9.9% to $10.2 million in 2002 from $9.3
million in 2001.

Software DRM. Cost of revenues for software DRM increased by 8.4% to $8.4
million in 2002 from $7.8 million in 2001 as a result of the related increase in
sales. Gross margin for software DRM decreased to 79.0% in 2002 from 79.8% in
2001.

Enterprise security. Cost of revenues for enterprise security increased by 17.0%
to $1.8 million in 2002 from $1.6 million in 2001 as a result of the increase in
sales of eToken. Gross margin decreased to 80.6% in 2002 from 80.9% in 2001.

Gross profit increased by 5.3% to $39.3 million in 2002 from $37.3 million in
2001. Our gross margin decreased to 79.3% in 2002 from 80.0% in 2001.

Research and development

Research and development expenses increased 10.9% to $12.2 million in 2002 from
$11.0 million in 2001. This increase was primarily due to the acquisition of
Preview Systems Inc. in July 2001. As a result of the acquisition, the salary
and related expenses for research and development personnel increased by
$670,000 and the facility costs for a new research and development center in
Portland, Oregon increased by $550,000. As a percentage of revenues, research
and development expenses increased to 24.7% in 2002 from 23.7% in 2001.

Selling and marketing

Selling and marketing expenses remained relatively stable with a slight decrease
of 2.2% to $22.0 million in 2002 from $22.5 million in 2001. As a percentage of
revenues, selling and marketing expenses decreased to 44.4% in 2002 from 48.2%
in 2001.

General and administrative

General and administrative expenses decreased 18.4% to approximately $7.2
million in 2002, from $8.9 million in 2001. This decrease resulted primarily
from the adoption of SFAS No. 142, "Goodwill and Other Intangible Assets,"
pursuant to which in 2002 we ceased amortizing goodwill.

In 2001, we amortized $2.0 million of goodwill. As a percentage of revenues,
general and administrative expenses decreased to 14.6% in 2002 from 19.0% in
2001.

Impairment of intangible assets

In 2001, in light of anticipated industry conditions, recent changes in our
business strategies, and prevailing and anticipated results of operations, we
conducted an evaluation of the carrying value and amortization periods of our
recorded intangible assets which resulted in an impairment charge of $5.2
million relating to a write-off of intangible assets with respect to the
EliaShim Ltd. acquisition at the end of 1998.

Financial income (expenses), net


                                       39





<PAGE>


Financial income, net, was $491,000 in 2002 compared to financial expenses, net
of $410,000 in 2001. This change was primarily attributable to the increase in
our financial income related to foreign currency translation differences in the
amount of $1.0 million, and a decrease in financial expenses due to an
impairment of available-for-sale marketable securities in the amount of $613,000
which was partially offset by a decrease in interest income on marketable
securities and bank deposits in the amount of $775,000.

Other expenses, net

Other expenses, net, were $932,000 in 2002 compared to $3.4 million in 2001.
Other expenses in 2002 were primarily generated by an impairment of our
investment in Tamir Fishman Ventures II LLC in the amount of $1.0 million, as a
result of significant uncertainty over the future realization of the investment.
Other expenses in 2001 were primarily generated by the write off of our
investment in FAST Multimedia Inc. in the amount of $3.4 million, since we
estimated that the carrying amount of our investment in FAST would not be
recoverable.

Taxes (benefit) on income

Taxes on income were $2.7 million in 2002 compared to an income tax benefit of
$347,000 in 2001. Taxes on income in 2002 were primarily due to income taxes
from ongoing operations of $238,000 and due to an increase of the valuation
allowance for deferred tax assets of approximately $2.5 million. The increase of
the valuation allowance was due to uncertainties related to our ability to use
certain of our deferred tax assets, consisting of our German subsidiary's net
operating losses carried forward. The income tax benefit in 2001 was primarily
due to an increase of the deferred tax asset, in the amount of approximately
$486,000 related to certain foreign net operating losses carried forward, offset
by an income tax provision from ongoing operations of approximately $139,000. In
2001, we provided a valuation allowance on a portion of the deferred tax assets
relating to our German subsidiary for which we believed that it was more likely
than not that the remaining net deferred tax assets of approximately $3.4
million would be realized, principally based upon its strong earnings history
and forecasted taxable income. We also believed that the loss in 2001 from our
German subsidiary was an aberration rather than a continuing condition. In 2002
several developments were considered in determining the need for an increase in
the valuation allowance, including the continuing market decline in Germany,
increasing uncertainty and decrease of visibility in the market as a whole, a
significant decrease in sequential quarterly revenue levels and the lack of
achieving our forecasted results in Germany for 2002. As a result of our
assessment, we increased the valuation allowance on the deferred tax asset in
the German subsidiary in the amount of approximately $2.5 million.

B. LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity are our cash, cash equivalents and marketable
securities and our cash flow from operations. As of December 31, 2003, we had
cash, cash equivalents and marketable securities aggregating $19.5 million.

Our operating activities provided cash in the amount of $5.9 million in 2003 and
$4.2 million in 2002, and used cash of $5.0 million in 2001. The improvement in
2003 compared to 2002 and 2001 was primarily attributable to our moving from a
net loss to a net income position.

Our investing activities used cash in the amount of $2.6 million in 2003
primarily due to the purchase


                                       40





<PAGE>


of property and equipment in the amount of $913,000 and an investment in Tamir
Fishman Ventures II LLC in the amount of $1.7 million. Our investing activities
used cash in the amount of $2.5 million in 2002 primarily due to the purchase of
property and equipment in the amount of $1.1 million, and an investment in and
loans to affiliates in the amount of $1.0 million. Our investing activities
provided cash in the amount of $3.4 million in 2001 primarily due to proceeds
from the sale of marketable securities in the amount of $11.0 million that was
offset by purchase of property and equipment in the amount of $1.2 million,
investment in and loans to an affiliate in the amount of $650,000, payment for
the purchase of assets from Preview Systems, Inc. in the amount of $5.2 million
and an investment in Tamir Fishman Ventures II LLC in the amount of $1.2
million.

Our financing activities provided cash in the amount of $456,000 in 2003 due to
the proceeds from the exercise of stock options by employees. In 2002, our
financing activities did not use or provide any cash. Our financing activities
used cash in the amount of $261,000 in 2001 due to purchase of treasury shares.

We had working capital of $26.6 million as of December 31, 2003, $22.7 million
as of December 31, 2002 and $24.6 million as of December 31, 2001.

Our obligation for accrued severance pay under Israel's Severance Pay Law as of
December 31, 2003 was $3.2 million, of which $2.3 million was funded through
deposits into severance pay funds, leaving a net obligation of $900,000.


                                       41





<PAGE>


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

INVESTMENTS

Athena Research Ltd. In December 1998, we signed a strategic agreement with
Athena Research Ltd. (our former partner in Aladdin Knowledge Systems Japan Co.)
pursuant to which we formed an entity named Athena Smart Card Solutions Ltd.
which develops and markets smart card solutions. To date, we have invested an
aggregate of $542,000 in the share capital of Athena, representing a 35.7%
ownership interest, and have made aggregate loans of $2.5 million, both of
which had been written-off as of December 31, 2003.

CORPORATE TAX

Israeli companies generally are subject to income tax at the corporate rate of
36%. We benefit from Israeli government tax exemption programs that reduce our
effective tax rate. We currently have two effective expansion programs that have
been granted approved enterprise status and one expansion program that is
pending approval. Therefore, we are eligible for tax benefits under the Israeli
Law for the Encouragement of Capital Investments, 1959. These programs expire at
the end of 2004, 2006 and 2008, respectively. 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
or four years in which these investment programs produced taxable income and are
currently subject to a reduced tax rate of between zero and 20% for the
remaining six or eight years of the program, depending on the program. In order
to enjoy these benefits, we have determined not to declare dividends or
otherwise distribute earnings out of tax exempt income. The availability of
these tax benefits is subject to certain requirements, including making
specified investments in property and equipment, and financing a percentage of
investments with share capital. If we do not meet these requirements in the
future, the tax benefits may be canceled and we could be required to refund any
tax benefits that we have already received, plus interest and penalties thereon
.. See "Israeli Taxation--Law for the Encouragement of Capital Investments,
1959." Since our taxable income is derived from more than one approved
enterprise program and since part of our taxable income is not derived from an
approved enterprise (including any taxable income of our subsidiaries), our
effective tax rate is a weighted average rates based on the various applicable
rate and tax exemptions.

We may apply for approved enterprise status for additional investment programs.
If approved, new benefit periods would apply for those programs. We will need to
demonstrate that future investment programs or expansion plans require capital
investments in order to apply for approved enterprise status. We cannot assure
you that we will receive approved enterprise status in the future for our
capital investments or that the tax benefits for approved enterprises will
continue at current levels.

As of December 31, 2003, the net operating loss carry-forwards of our
subsidiaries for tax purposes amounted to $22.3 million, the majority of which
related to our U.S. and German subsidiaries. A subsidiary's net operating loss
carry-forwards for tax purposes relating to a jurisdiction are generally
available to offset future taxable income of such subsidiary in that
jurisdiction, subject to applicable expiration dates.


                                       42





<PAGE>


C. RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC.

The software industry is characterized by rapid product change resulting from
new technological developments, performance improvements and lower hardware
costs. We believe that our future growth depends to a large extent on our
ability to be an innovator in the development and application of hardware and
software technology utilizing, among other things, our advanced security
algorithms. We work closely with our customers and prospective customers to
determine their requirements and to design enhancements and new features to meet
their needs. We intend to expand our research and development efforts, and are
currently developing new products that incorporate both technology presently
used in our products and technology developed for new applications. Our research
and development activities have led to periodic releases of improved versions of
our HASP, HARDLOCK, Privilege and eSafe products, which offer increased
functionality. In addition, our research and development efforts have resulted
in the release of eToken in June 2000. We intend to expand our research and
development efforts, and we are currently developing new products that
incorporate both technology presently used in our products and technology that
we are developing for new applications.

Research and development expenditures increased to approximately $12.75 million
during 2003, as compared to $12.24 million during 2002 and $11.04 million during
2001. This increase was due to our need to continue investing costs to update
current products and develop new products to remain competitive. Accordingly, we
expect to expand our research and development efforts, and we are currently
developing new products that incorporate both technology presently used in our
products and technology that we are developing for new applications.

D. TREND INFORMATION

There is a trend toward integration of security software inside pre-configured,
easy to install hardware appliances. Although Aladdin does not have its own
hardware appliance, we have introduced an innovative Virtual Appliance concept
that easily allows integration of eSafe products with almost any hardware
appliance. We are also working on strategic alliances with major hardware
manufacturers to ensure that eSafe's Virtual Appliance platform works with their
high-end hardware appliances. In addition there is an element of service that
must be provided to customers when selling hardware devices.

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

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

The introduction of Active Directory technology by Microsoft and the usage of
their Certificate Server as a mainstream authentication platform has opened up
the market to mainstream usage of Smartcard based technology. Active Directory
is Microsoft's trademarked directory service, an integral part of the Windows
2000 architecture. Like other directory services Active Directory is a
centralized and


                                       43





<PAGE>


standardized system that automates network management of user data, security,
and distributed resources, and enables interoperation with other directories.
Active Directory is designed especially for distributed networking environments.
There is a clear increase in adaptation of Public Key Infrastructure (PKI)
technology and usage of Token / Smartcard for authentication of users' access to
the network. PKI enables users of an essentially non-secure, public network such
as the Internet to securely and privately exchange data and money through the
use of a public and a private cryptographic key pair that is obtained and shared
through a trusted authority. The public key infrastructure provides for a
digital certificate that can identify an individual or an organization and
directory services that can store and, when necessary, revoke the certificates.

E. OFF-BALANCE SHEET ARRANGEMENTS

We are not a party to any material off-balance sheet arrangements. In addition,
we have no unconsolidated special purpose financing or partnership entities that
are likely to create material contingent obligations.

F. TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

The following table summarizes our contractual obligations and commercial
commitments as of December 31, 2003:

<TABLE>
<CAPTION>
                                               Payment due by period
                                ----------------------------------------------------
                                           Less
                                          than 1      2        3       4     After 4
Contractual obligations          Total     year     years    years   years    years
-----------------------------   -------   ------   ------   ------   -----   -------
                                                   (In thousands)
<S>                             <C>       <C>      <C>      <C>       <C>      <C>
Operating leases(1)             $ 7,042   $2,551   $1,978   $1,735    $474     $304
Purchase obligations(2)           3,082    1,063      940      790     197       92
Other long-term commitment(3)     3,410    1,279    1,705      426      --       --
                                -------   ------   ------   ------    ----     ----
Total contractual obligations   $13,534   $4,893   $4,623   $2,951    $671     $396
                                =======   ======   ======   ======    ====     ====
</TABLE>

(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 $5.1 million had been invested at
     December 31, 2003) 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.



                                       44





<PAGE>


G. SAFE HARBOR

All information that is not historical in nature disclosed under "Item 5.
Operating and Financial Review and Prospects--Off-Balance Sheet Arrangements"
and "--Tabular Disclosure of Contractual Obligations" is deemed to be a
forward-looking statement.


                                       45





<PAGE>


Item 6. Directors, Senior Management and Employees

A. DIRECTORS AND SENIOR MANAGEMENT

As of May 1, 2004, our directors, senior management and key employees are as
follows:

<TABLE>
<CAPTION>
Name                      Age   Position with the Company
----                      ---   -------------------------
<S>                        <C>  <C>
Jacob (Yanki) Margalit     41   Chairman of the Board and Chief Executive Officer

David Assia(1)             52   Director

Menahem Gutterman(1)(2)    65   Director

Orna Berry(1)(2)           55   Director

Dany Margalit              36   Director and Executive Vice President, Technologies

Erez Rosen                 43   Chief Financial Officer

Ami Dar                    44   President of Aladdin Knowledge Systems Inc.

Steve Langerock            49   Chief Executive Officer of Aladdin Knowledge
                                Systems Inc.

Leedor Agam                40   Vice President eBusiness and eToken Solutions.

Dror Irani                 44   Vice President, eSafe Business Unit Manager

Avishai Ziv                45   Vice President Business Development

Shimon Gruper              43   Executive Vice President, Internet Technologies

Avi Barir                  50   Vice President Software Commerce

Stephen Axel               48   Vice President Global Marketing
</TABLE>

----------
(1)  Member of the audit committee

(2)  Outside Director

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

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


                                       46





<PAGE>


Dr. Menahem Gutterman has been an outside director since December 31, 2000. Dr.
Gutterman is a Senior Managing Partner of Atid Capital Partners. Dr. Gutterman
has served as Executive Vice President and Head of the Operations Information
Systems Division of Israeli Discount Bank Ltd since 1992. Dr. Gutterman served
as General Manager's Assistant at Israel Discount Bank Ltd. from 1981-1992.
Prior to joining Israel Discount Bank Ltd., Dr. Gutterman served as Vice
President of Sales and Services at Elscint Ltd., as well as Managing Director of
Clal Systems. Until 2000, Dr. Gutterman served as a senior lecturer at Tel Aviv
University, Faculty Management, and School of Business Administration. Dr.
Gutterman holds a D.Sc. in Mathematics.

Dr. Orna Berry has been an outside director since December 31, 2001. Dr. Berry
is a venture partner in Gemini Israel Funds Ltd. and since 2000 has served as
the active Chairperson in both Lambda Crossing, Ltd., and in Riverhead Networks,
Inc., which was sold to Cisco in April 2004. Dr. Berry served as the Chief
Scientist of the Ministry of Industry and Trade of the Government of Israel from
1997-2000 and Co-President of ORNET Data Communications Technologies Ltd. from
1993-1997. From 1992-1993, Dr. Berry served as a consultant to Intel
Communications Division and Elbit Systems, Ltd. Dr. Berry received her Ph.D. in
Computer Science from the University of Southern California and M.A. and B.A.
degrees in Statistics and Mathematics from Tel Aviv University and Haifa
University.

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

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

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

Steve Langerock began as Chief Financial Officer of Aladdin Knowledge Systems
Inc. in 1996, was promoted to Software Commerce Division president in 1998 and
has been Chief Executive Officer of Aladdin Knowledge Systems Inc. since 1999.
He joined Glenco in 1995 and was promoted to Chief Financial Officer and General
Manager in 1996. Prior to joining Glenco, he was Administration/Operations
Manager for Advantest, a world leader in the production of semiconductor test
equipment. Mr. Langerock has extensive experience in the sales, production and
financial arenas. Mr. Langerock holds a BA in Business Management and Accounting
and is a CPA and CPIM.

Leedor Agam joined us in January 2001 as Vice-President eBusiness and eToken
Solutions, heading up the company's portable authentication and network security
product line. Prior to joining us, Mr. Agam served as Vice President of Business
Development for Cylink/AR where he focused on technology acquisition and
partnerships, and also held several management positions in Marketing and
Channel


                                       47





<PAGE>


management where he gained extensive experience in bringing to market high
technology security solutions. Mr. Agam received an MBA from City University of
London, and a technology bachelor's degree in Industrial Management from Tel
Aviv University.

Dror Irani joined Aladdin in 1999 and is currently Vice President eSafe Business
Unit Manager. Within Aladdin he has accelerated Aladdin's revenue growth as Vice
President of Sales for Internet Security, Vice President of Global Sales and in
his current role, Mr. Irani is fully responsible for the entire eSafe Content
Security product line (strategy development, R&D, business development, global
channel expansion and sales execution). Prior to joining Aladdin, Mr. Irani
developed extensive international sales expertise and management capability
within the hi-tech industry. His prior executive roles include sales and
marketing positions at Efrat and Comverse Network Systems. Mr. Irani holds an
MBA, an MA in Economics as well as BSc in Computer Science from Hebrew
University in Jerusalem and has recently completed The General Manager Program
(TGMP) at Harvard Business School.

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

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

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

Stephen Axel joined us in December, 2001, as the Vice President of Global
Marketing. Prior to joining us, Mr. Axel was the Chief Marketing Officer for
VASCO Data Security International, a global provider of security solutions. He
brings 20 years of marketing experience to our company and has extensive and
proven expertise in brand strategy and management, product positioning, and the
development of integrated marketing campaigns. A graduate of the University of
California-Santa Barbara with a degree in Business Economics, Mr. Axel received
his MBA degree from Northwestern University's J.L. Kellogg School of Management.


                                       48





<PAGE>


Yanki Margalit and Dany Margalit are brothers.

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

B. COMPENSATION

During the year ended December 31, 2003, we paid in the aggregate direct
remuneration to our directors and officers as a group who served in the capacity
of director or executive officer during such year (not including our
subsidiaries), approximately $1,232,763. This amount includes directors' fees
and expenses, but does not include amounts expended by us for automobiles made
available to our officers, expenses (including business travel, professional and
business association dues and expenses) reimbursed to officers and other fringe
benefits commonly reimbursed or paid by companies in Israel. In addition, we set
aside or accrued approximately $130,707 to provide pension, retirement or
similar benefits.

Certain of the compensation paid to our directors in 2003 is paid in the form of
options under our Aladdin Knowledge Systems Ltd. 1999 Israeli Share Option Plan.
In 2003, we granted options to purchase 2,500 ordinary shares under the 1999
Israeli Share Option Plan to each of Mr. Assia, Dr. Gutterman and Dr. Berry. The
exercise price of the options was $2.67 and they vest in various portions over
the course of the 12 to 48 month period from the date of grant.

On December 16, 2003, following approval by our audit committee and board of
directors, our shareholders approved the provision of indemnification to our
directors and officers for up to $7 million (in addition to any amounts paid out
under an insurance policy) in addition to their exemption from the duty of care,
to the maximum extent permitted under Israeli law. Our current insurance policy
covers our directors and officers in amounts of up to $10 million (in the
aggregate), however, such amount is to be increased to $15 million, effective
June 1, 2004, subject to approval by our audit committee, board of directors and
shareholders.

C. BOARD PRACTICES

The Effect of the Company's New Articles of Association on Board Practices

On December 16, 2003, our shareholders replaced our Articles of Association with
a completely new set of Articles of Association which reflect many changes
implemented in order to conform with the Israeli Companies Law - 1999. The
changes to our Articles of Association include the following, which affect the
practices of our board of directors and management:

We are authorized to exempt in advance an "Office Holder" (as defined in the
Companies Law) from all or any of his or her liability for damages in
consequence of a breach of his or her duty of care to us.

We may enter into a contract for the insurance of our Office Holder against (i)
a breach of the duty of care owed to us or a third party, (ii) a breach of the
fiduciary duty owed to us, provided that the Office Holder acted in good faith
and had reasonable grounds to believe that his or her action would not harm our
interests; and (iii) a monetary liability imposed on him or her in favor of a
third party, for an act that he or she performed by virtue of being an Office
Holder of us.


                                       49





<PAGE>


We are authorized to undertake to give an undertaking in advance to indemnify an
Office Holder for an obligation or expense, imposed on him or her in consequence
of an act done in his or her capacity as an Office Holder.

To the extent permitted by the Companies Law, our board of directors will have
the ability to declare dividends (in cash or in kind) to shareholders, without
shareholder approval.

For a description of our policies for indemnification of directors and officers,
please refer to Item 10: Indemnification of Directors and Officers, which is
hereby incorporated by reference.

Board of Directors

Although our shareholders are free to determine the size of our board, until
such a determination is made, our Articles of Association, as amended in 2003,
provide for a board of directors of not less than two, and not more than eight
members. Each director, with the exception of outside directors who are elected
to serve for set periods of time as described below, is elected to serve until
the next annual general meeting of shareholders and until his successor has been
elected. A vacancy in our board, including a vacancy resulting from an
enlargement of the board by resolution of the board of directors, may be filled
by a vote of a majority of the directors then in office, even if less than a
quorum. A director elected by the board as a result of such vacancy shall be
elected to hold office until the next annual meeting of our shareholders.

Our officers serve at the discretion of the board of directors.

Substitute (Alternate) Directors

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

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

Outside Directors

The Israeli Companies Law - 1999 requires Israeli companies with shares that
have been offered to the public inside or outside of Israel to appoint two
outside directors. No person may be appointed as an outside director if the
person or the person's relative, partner, employer or any entity under the
person's control, has or had, on or within the two years preceding the date of
the person's appointment to serve as outside director, any affiliation with the
company or any entity controlling, controlled by or under common control with
the company.

The term "affiliation" includes:

     o    an employment relationship;

     o    a business or professional relationship maintained on a regular basis;

     o    control of the company; and

     o    service as an office holder.


                                       50





<PAGE>


No person may serve as an outside director if the person's position or other
business activities create, or may create, a conflict of interest with the
person's responsibilities as an outside director or may otherwise interfere with
the person's ability to serve as an outside director.

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

Pursuant to the requirements of the Israeli Companies Law - 1999, Dr. Orna Berry
was appointed as an outside director on December 31, 2001 for a three-year term
that expires on December 31, 2004. On December 16, 2003 our shareholders
reelected Dr. Menahem Gutterman, our outside director who has served as an
outside director of the Company since December 31, 2000, for an additional
period of three years commencing as of January 1, 2004, and until his respective
successor is duly elected and qualified.

An outside director is entitled to compensation as provided in regulations
promulgated under the Israeli Companies Law - 1999 and is otherwise prohibited
from receiving any other compensation, directly or indirectly, in connection
with service provided as an outside director.

Audit Committee

The Israeli Companies Law - 1999 requires public companies to appoint an audit
committee. The responsibilities of the audit committee include identifying
irregularities in the management of the company's business and approving related
party transactions as required by law. An audit committee must consist of at
least three directors, including the outside directors of the company. The
chairman of the board of directors, any director employed by or otherwise
providing services to the company, and a controlling shareholder or any relative
of a controlling shareholder, may not be a member of the audit committee.

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

Internal Auditor

Under the Israeli Companies Law - 1999, the board of directors must appoint an
internal auditor, nominated by the audit committee. The role of the internal
auditor is to examine, among other matters, whether the company's actions comply
with the law and orderly business procedure. Under the Companies Law, the
internal auditor may be an employee of the company but not an office holder, or
an affiliate, or a relative of an office holder or affiliate, and he may not be
the company's independent accountant or its representative.

D. EMPLOYEES

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


                                       51





<PAGE>


<TABLE>
<CAPTION>
                                Year ended December 31,
                                -----------------------
Activity                           2003   2002   2001
--------                           ----   ----   ----
<S>                                 <C>    <C>    <C>
Production                           53     53     56
Research and development            175    181    183
Marketing and sales                  77     70     84
Administration and management        46     50     51
                                    ===    ===    ===
Total                               351    354    374
                                    ===    ===    ===
</TABLE>

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

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

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

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


                                       52





<PAGE>


E. SHARE OWNERSHIP

All of the persons listed above, under the caption "Directors, Senior Management
and Employees" who are employed by us own shares and/or options to purchase
ordinary shares. Except as set forth below, none of the named directors or
employees owns shares and/or options amounting to 1% or more of our outstanding
ordinary shares. As of May 1, 2004, Yanki Margalit beneficially held 2,184,128
ordinary shares which represented 18.35% of our issued and outstanding share
capital, and Dany Margalit held 1,093,195 ordinary shares which is 9.21% of our
issued and outstanding capital. Information regarding our share option plans
presented in Note 14D to our consolidated financial statements is incorporated
herein by reference.

Item 7. Major Shareholders and Related Party Transactions

A. MAJOR SHAREHOLDERS

The following table sets forth certain information as of May 1, 2004, regarding
beneficial ownership (as defined in Rule 13d-3 under the Securities Exchange Act
of 1934) of ordinary shares as of May 1, 2004 by each person who is known to own
at least 5% of our outstanding ordinary shares. The table also includes the
number of shares underlying options that are exercisable within 60 days of May
1, 2004. The voting rights of our major shareholders do not differ from the
voting rights of other holders of our ordinary shares.

<TABLE>
<CAPTION>
                                           Number of
Name and Address                         Shares Owned   Percent of Shares*
----------------                         ------------   ------------------
<S>                                        <C>                <C>
Yanki Margalit........................     2,184,128          18.35%
15 Beit Oved Street
Tel Aviv 61110, Israel

Dany Margalit.........................     1,093,195           9.21%
15 Beit Oved Street
Tel Aviv 61110, Israel

Juniper Trading Services..............     1,417,400          11.94%
9 Bermudian Road
Hamilton Hill
Bermuda

Diker Management, LLC.................       647,156           5.45%
745 Fifth Avenue, Suite 1409
New York, New York 10151
</TABLE>

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

As of May 1, 2004, there were a total of 73 holders of record of our issued and
outstanding ordinary shares, of which 44 were registered with addresses in the
United States. Such United States holders were, as of such date, the holders of
record of approximately 72% of our issued and outstanding ordinary shares.


                                       53





<PAGE>


B. RELATED PARTY TRANSACTIONS

     Stock Option Grant to Mr. Dany Margalit, our Director and Executive Vice
President

On December 16, 2003 our shareholders, following approval by our audit committee
and board of directors, approved that our director Mr. Dany Margalit, be granted
options to purchase 65,000 of our ordinary shares at an exercise price of $8.52
and subject to a four-year vesting schedule.

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

In the final quarter of 2002 our audit committee, board of directors and
shareholders approved the amendment of Mr. Yanki Margalit's employment terms.
Effective as of October 2002, Mr. Yanki Margalit's annual salary is $150,000. In
addition, commencing in 2002, Mr. Yanki Margalit receives an annual performance
based bonus equivalent to 1.5% of year to year increases in our annual revenues.
Commencing in the fourth quarter of 2002, Mr. Yanki Margalit receives a
quarterly performance based bonus equivalent to 3% of our quarterly net profits.
On April 14, 2003, Mr. Yanki Margalit received options to purchase 100,000 of
our ordinary shares at an exercise price per share of $1.20 which will be
subject to a 3 year vesting schedule such that one third of these options will
vest annually. Mr. Yanki Margalit also receives the use of an automobile from
the Company, 25 days of paid vacation per year as well as other benefits
commonly paid by companies in Israel.

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

Pursuant to an undertaking, during each of 12 months ending January 2004, Mr.
Margalit purchased stock on the open market equal to 15 percent of his net
salary. The 12-month purchase plan was executed by Mr. Margalit, irrespective of
the price of the stock which ranged between $2.25 and $12.95 subject to
applicable law.

     Loan Agreements with Officers

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

     Strategic Agreement with Athena Research Ltd.

In December 1998, we signed a strategic agreement with Athena Research Ltd. (our
former partner in Aladdin Knowledge Systems Japan Co.), under which we formed a
joint venture named Athena Smartcard Solutions Ltd. which develops and markets
smartcard solutions based on our Smartcard Environment (ASE) technology. Since
1999, we have provided Athena with certain loans from time to time up and until
the first quarter of 2003. As of May 2004, the aggregate outstanding loans to
Athena amounted to $2,484,000. We have made a provision in our financial
statements with respect to the likelihood that Athena will be able to repay its
debt to us.


                                       54





<PAGE>


     Indemnification Agreements with Our Directors and Officers

On December 16, 2003, following approval by our audit committee and board of
directors, our shareholders approved the provision of indemnification to our
directors and officers for up to $7 million (in addition to any amounts paid out
under an insurance policy) in addition to their exemption from the duty of care,
to the maximum extent permitted under Israeli law. Our shareholders approved
this indemnification for all of our existing directors and for any future
directors.

C. INTERESTS OF EXPERTS AND COUNSEL

Not applicable.

Item 8. Financial Information

A. CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION

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

Legal Proceedings

     Aladdin Systems Inc.

During 1988, we became aware of the possibility that Aladdin Systems Inc. was
infringing our trademark. We did not however file a complaint against Aladdin
Systems Inc. until October 2003, when Aladdin Systems Inc. issued a press
release announcing its release of a new spam-blocking software product under our
trademark. Upon learning of this product, we proceeded to file a complaint and
request for preliminary relief against Aladdin Systems Inc., Aladdin Enterprise
Solutions Inc. and Aladdin Systems Holding, Inc. We have recently reached a
settlement with these companies as well as with Microcomputer Software, Inc.,
who recently purchased Aladdin Systems Inc.

     Investigation against former distributor

During recent years we have become aware of and are currently investigating the
possibility that one of our former Asian distributors is infringing our
intellectual property. We are currently still investigating this possible
infringement however, should we come to the conclusion that our intellectual
property is being infringed upon, we will take appropriate steps to protect our
intellectual property.

     Network Commerce Inc.

On May 3, 2002, a claim was brought against our United States subsidiary,
Aladdin Knowledge Systems, Inc. by Network Commerce Inc. In this action, the
plaintiff claimed that our software, including Privilege SCP infringed the
plaintiff's United States patent. The plaintiff requested a preliminary and
permanent injunction, damages and attorneys' fees. Aladdin denied the
allegations of the claim and asserted that plaintiff's patent is invalid. This
claim was settled in December 2002 and received the required court approval on
April 25, 2003.

     Hilgraeve, Inc., Symantec Corporation

On October 2, 2002, a claim was brought by Hilgraeve, Inc., the
predecessor-in-interest of Symantec Corporation, against us, our United States
subsidiary and other companies, including one of our


                                       55





<PAGE>


resellers who we agreed to represent and indemnify. The plaintiff claimed in
this action that our eSafe product infringes the plaintiff's United States
patent. The plaintiff requested a preliminary and permanent injunction, damages
and reasonable attorney fees. This claim was settled in the beginning of March
2004. The terms of the settlement, which did not include admission of liability,
included a license and covenant not to sue.

     Injunction against former distributor

In November 2003, we won an injunction against a former Brazilian distributor
and its owners, Mauro Moreira and Luciane Moreira, of Rio de Janeiro. The
injunction requires the defendants to cease several actions that violate
obligations undertaken in a 1999 agreement they entered into with us. A sequence
of abuses, misrepresentations and questionable actions of the Brazilian
defendants led to the termination of distribution agreements and caused us to
file the lawsuit against them in November 2003. On November 26, 2003, the
Brazilian court rendered its preliminary decision and accepted all our
injunction requests. In its decision, the court ordered the defendants to cease
from making use of the name "Aladdin" in any way, and to refrain from offering
or selling any of our products. The court also stated that the defendants shall
not offer or sell any product that competes with our products for a period of
one year as of their knowledge of the decision. According to the decision, all
of our confidential material that was held by the former distributor must be
delivered to us. The defendants filed an appeal against this decision and the
Supreme Court of the State of Rio de Janeiro decided to suspend the effects of
the injunction alleging that the lawsuit is very complex and the court of first
level should await to hear all the contests of all defendants. We filed
arguments against the defendants' appeal and against the decision of the State
Court, yet the appellate court upheld its decision to suspend the effects of the
injunction.

     Andrew Pickholtz

Our subsidiary Aladdin Knowledge Systems Inc., and we were named as defendants
in a complaint filed on May 19, 2004, by Andrew Pickholtz in the U.S. District
Court for the Northern District of California alleging that our HASP, Hardlock
and MicroGuard products infringe a patent owned by Mr. Pickholtz. Mr. Pickholtz
is seeking damages in an unspecified amount relating to such alleged
infringement, declaratory judgment, enhanced damages, interest, attorneys' fees
and any further relief the court may deem appropriate. We believe the complaint
is without merit and intend to defend ourselves vigorously. Any liability we
incur in connection with this complaint could materially harm our business and
financial position and, even if we defend ourselves successfully, there is a
risk that management distraction in dealing with this complaint could harm our
results.

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

Dividend Distributions

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

B. SIGNIFICANT CHANGES

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


                                       56





<PAGE>


Item 9. The Offer and Listing

A. OFFER AND LISTING DETAILS

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

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
Period                                                            High      Low
--------------------------------------------------------------------------------
<S>                                                              <C>      <C>
May 2004                                                         $27.70   $20.31
--------------------------------------------------------------------------------
April 2004                                                       $26.39   $18.90
--------------------------------------------------------------------------------
March 2004                                                       $19.80   $14.27
--------------------------------------------------------------------------------
February 2004                                                    $17.43   $11.31
--------------------------------------------------------------------------------
January 2004                                                     $12.95   $ 8.73
--------------------------------------------------------------------------------
December 2003                                                    $ 9.89   $ 7.70
--------------------------------------------------------------------------------
November 2003                                                    $ 9.39   $ 7.99
--------------------------------------------------------------------------------
October 2003                                                     $10.10   $ 5.81
--------------------------------------------------------------------------------
September 2003                                                   $ 7.98   $ 6.17
--------------------------------------------------------------------------------
First Quarter 2004                                               $19.80   $ 8.73
--------------------------------------------------------------------------------
Fourth Quarter 2003                                              $10.10   $ 5.81
--------------------------------------------------------------------------------
Third Quarter 2003                                               $ 7.98   $ 3.75
--------------------------------------------------------------------------------
Second Quarter 2003                                              $ 4.10   $ 2.59
--------------------------------------------------------------------------------
First Quarter 2003                                               $ 3.38   $ 2.25
--------------------------------------------------------------------------------
Fourth Quarter 2002                                              $ 2.67   $ 0.85
--------------------------------------------------------------------------------
Third Quarter 2002                                               $ 2.35   $ 1.20
--------------------------------------------------------------------------------
Second Quarter 2002                                              $ 3.80   $ 2.30
--------------------------------------------------------------------------------
First Quarter 2002                                               $ 3.86   $ 2.81
--------------------------------------------------------------------------------
2003                                                             $10.10   $ 2.25
--------------------------------------------------------------------------------
2002                                                             $ 3.86   $ 0.85
--------------------------------------------------------------------------------
2001                                                             $ 5.91   $ 2.43
--------------------------------------------------------------------------------
2000                                                             $44.75   $ 3.62
--------------------------------------------------------------------------------
1999                                                             $19.31   $ 6.88
--------------------------------------------------------------------------------
</TABLE>

B. PLAN OF DISTRIBUTION

Not applicable.

C. MARKETS

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


                                       57





<PAGE>


listing of our ordinary shares on the Tel Aviv Stock Exchange immediately
following the filing of this report.

D. SELLING SHAREHOLDERS

Not applicable.

E. DILUTION

Not applicable.

F. EXPENSES OF THE ISSUE

Not applicable.

Item 10. Additional Information

A. SHARE CAPITAL

Not Applicable

B. MEMORANDUM AND ARTICLES OF ASSOCIATION

The Israeli Companies Law and our New Articles of Association

The Israeli Companies Law

We are subject to the provisions of the Israeli Companies Law - 1999 (the
"Companies Law"), which became effective on February 1, 2000. The Companies Law
codifies the fiduciary duties that "office holders," including directors and
executive officers, owe to a company. An office holder, as defined in the
Companies Law, is a director, general manager, chief business manager, deputy
general manager, vice general manager, executive vice president, vice president,
another manager directly subordinate to the managing director or any other
person assuming the responsibilities of any of the forgoing positions without
regard to such person's title. Each person listed in the table in "Item 6.
Directors, Senior Management and Employees" above is an office holder. Under the
Companies Law, all arrangements as to compensation of office holders who are not
directors require approval of the board of directors or a committee thereof.
With the exception of compensation to outside directors in an amount specified
in the regulations discussed above, arrangements regarding the compensation of
directors also require audit committee and shareholder approval.

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


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<PAGE>


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

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

     o    all of the directors shall be permitted to vote on the matter and
          attend the meeting in which the matter is considered; and

     o    the matter requires approval of the shareholders at a general meeting.

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

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

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


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<PAGE>


          o    any amendment to the articles of association;

          o    an increase of the company's authorized share capital;

          o    a merger; or

          o    approval of interested party transactions that require
               shareholder approval under the Companies Law.

In addition, any controlling shareholder, any shareholder who knows that it
possesses power to determine the outcome of a shareholder vote and any
shareholder who has the power to appoint or prevent the appointment office
holder in the company is under a duty to act with fairness towards the company.
The Companies Law does not describe the substance of this duty. The Companies
Law requires that specified types of transactions, actions and arrangements be
approved as provided for in a company's articles of association and in some
circumstances by its audit committee, board of directors and by its
shareholders. In general, the vote required by the audit committee and the board
of directors for approval of these matters, in each case, is a majority of the
disinterested directors participating in a duly convened meeting.

Our New Articles of Association

On December 16, 2003 our shareholders approved our new Articles of Association.
Our objectives as stated in our Articles of Association are to engage in any
lawful activity.

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

Holders of ordinary shares have one vote per share, and are entitled to
participate equally in the payment of dividends and share distributions and, in
the event of our liquidation, in the distribution of assets after satisfaction
of liabilities to creditors. Our new 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 new Articles of Association require that we hold our annual general meeting
of shareholders once every calendar year and in accordance with the timing
requirements set forth under Israeli law, at a time and place determined by the
board of directors, upon at least 21 days prior notice to our shareholders. No
business may be commenced until a quorum of two or more shareholders are present
in person or by proxy. If within a half hour from the time appointed for the
meeting a quorum is not present, the meeting, shall be dissolved, but in any
other case it shall stand adjourned for one week, to the same day, time and
place, without it being necessary to notify the shareholders of such or such
other time and place as specified in the notice or to such later day and at such
time and place as the chairman may determine with the consent of an ordinary
majority. If a quorum is not present at the adjourned meeting within half and
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:


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<PAGE>


     o    amendments to our Articles of Association (other than modifications of
          shareholders rights as mentioned above);

     o    appointment or termination of our auditors;

     o    appointment and dismissal of directors;

     o    approval of acts and transactions requiring general meeting approval
          under the Companies Law;

     o    increase or reduction of our authorized share capital or the rights of
          shareholders or a class of shareholders;

     o    any merger; and

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

Indemnification of Directors and Officers

The Israeli Companies Law provides that a company may include in its articles of
association provisions allowing it to:

     1. partially or fully, exempt in advance, an office holder of the company
     from his responsibility for damages caused by the breach of his duty of
     care to the company.

     2. enter into a contract to insure the liability of an office holder of the
     company by reason of acts or omissions committed in his capacity as an
     office holder of the company with respect to the following:

          (a) the breach of his duty of care to the company or any other person;

          (b) the breach of his fiduciary duty to the company to the extent he
          acted in good faith and had a reasonable basis to believe that the act
          or omission would not prejudice the interests of the company; and


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<PAGE>


          (c) monetary liabilities or obligations which may be imposed upon him
          in favor of other persons.

     3. indemnify an office holder of the company for:

          (a) monetary liabilities or obligations imposed upon him in favor of
          other persons pursuant to a court judgment, including a compromise
          judgment or an arbitrator's decision approved by a court, by reason of
          acts or omissions of such person in his capacity as an office holder
          of the company; and

          (b) reasonable litigation expenses, including attorney's fees,
          actually incurred by such office holder or imposed upon him by a
          court, in an action, suit or proceeding brought against him by or on
          behalf of us or by other persons, or in connection with a criminal
          action from which he was acquitted, or in connection with a criminal
          action which does not require criminal intent in which he was
          convicted, in each case by reason of acts or omissions of such person
          in his capacity as an office holder.

The Companies Law provides that a company's articles of association may provide
for indemnification of an office holder post-factum and may also provide that a
company may undertake to indemnify an office holder in advance, provided such
undertaking is limited to types of occurrences, which, in the opinion of the
company's board of directors, are, at the time of the undertaking, foreseeable
and to an amount the board of directors has determined is reasonable in the
circumstances.

The Companies Law provides that a company may not indemnify or exempt the
liabilities of an office holder or enter into an insurance contract, which would
provide coverage for the liability of an office holder with respect to the
following:

     o    a breach of his fiduciary duty, except to the extent described above;

     o    a breach of his duty of care, if such breach was done intentionally,
          recklessly or with disregard of the circumstances of the breach or its
          consequences;

     o    an act or omission committed with the intent to unlawfully realize
          personal gain; or

     o    a fine or monetary settlement imposed upon him.

Under the Companies Law, the term office holder includes a director, managing
director, general manager, chief executive officer, executive vice president,
vice president, other managers directly subordinate to the managing director and
any other person fulfilling or assuming any such position or responsibility
without regard to such person's title.

The grant of an exemption, an undertaking to indemnify or indemnification of,
and procurement of insurance coverage for, an office holder of a company
requires, pursuant to the Companies Law, the approval of the company's audit
committee and board of directors, and, in certain circumstances, including if
the office holder is a director, the approval of the company's shareholders.


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<PAGE>


C. MATERIAL CONTRACTS

C-Signature Ltd.

In April, 2004, we entered into a convertible loan agreement with C-Signature
Ltd., an Israeli company engaged in the development of a novel biometric
identity recognition technology. According to the agreement, we will invest an
aggregate amount of $1,050,000 in C-Signature, of which $550,000 has already
been transferred to C-Signature as a convertible loan. Such loan will be
automatically converted into Series A Preferred Shares of C-Signature, unless
C-Signature fails to meet a certain agreed upon milestone or unless it ceases
development of its product. In both such cases the full amount of the loan, less
certain agreed upon amounts, will be repayable. Concurrently with the conversion
of the loan, we will invest the remaining $500,000 by purchasing additional
Series A Preferred Shares of C-Signature. Upon conversion of the loan and the
placement of the remainder of the investment amount, we will hold 19.9% of the
share capital of C-Signature, and shall be entitled in future events of issuance
of shares by C-Signature, to issuance of certain additional Series A Preferred
Shares, for no consideration. We intend to execute a cooperation and technology
license agreement with C-Signature according to which we will develop a line of
commercial products based on C-Signature's unique technology and C-Signature
shall grant us a license to its technology.

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 ordinary shares.

E. TAXATION

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

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

     General Corporate Tax Structure

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


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<PAGE>


     Law for the Encouragement of Capital Investments, 1959

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

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

A company, which qualifies as a "Foreign Investors' Company", is entitled to
further reductions in the tax rate normally applicable to Approved Enterprises.
Such benefits will be granted only to enterprises seeking approval not later
than June 30, 2004. Subject to certain conditions, a "Foreign Investors'
Company" is a company which has more than 25% of its combined shareholders'
investment in share capital (in terms of rights to profits, voting and the
appointment of directors) and in long term shareholders' loans made by persons
who are not residents of Israel. The percentage owned by nonresidents of Israel
for any tax year will be determined by the lowest percentage of any of the above
rights held by nonresidents during that year. Such a company will pay corporate
tax at reduced rates for an extended ten-year (rather than the otherwise
applicable seven-year) period and is exempt from any other tax on the
undistributed income from its Approved Enterprise:

For a company with foreign investment of:

<TABLE>
<CAPTION>
                                Company Tax Rate
                                ----------------
<S>                                    <C>
Over 25% but less than 49%             25%

49% or more but less than 74%          20%

74% or more but less than 90%          15%

90% or more                            10%
</TABLE>

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


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<PAGE>


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

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

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

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

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

     Law for the Encouragement of Industry (Taxes), 1969

The following preferred corporate tax benefits, among others, are available to
those companies deemed Industrial Corporations. We believe that we are an
Industrial Corporation. This provides us with the following benefits:

     o    deduction of purchases of know-how and patents over eight years for
          tax purposes;

     o    right to elect, under specified conditions, to file a consolidated tax
          return with additional related Israeli industrial companies and an
          industrial holding company; and

     o    deduction of certain share issuance expenses over three years for tax
          purposes.


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<PAGE>


     Taxation under Inflationary Conditions

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

     o    a special tax adjustment for the preservation of equity whereby
          certain corporate assets are classified broadly into Fixed (inflation
          resistant) Assets and Non-fixed (soft) Assets. Where a corporation's
          equity, as defined in such law, exceeds the depreciated cost of Fixed
          Assets, a tax deduction which takes into account the effect of the
          annual inflationary change on such excess is allowed (up to a ceiling
          of 70% of taxable income in any single tax year, with the unused
          portion permitted to be carried forward on a linked basis). If the
          depreciated cost of Fixed Assets exceeds a corporation's equity, then
          such excess multiplied by the annual inflation change is added to
          taxable income.

     o    depreciation deductions on Fixed Assets and losses carried forward are
          adjusted for inflation based on the increase in the Israeli Consumer
          Price Index.

     o    the law also provides for the full taxation of gains from the sale of
          certain traded securities, which would otherwise be taxed at a reduced
          rate when derived by certain categories of corporate taxpayers.

     Israeli Capital Gains Tax

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

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

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


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     Israeli Tax on Dividend Income

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

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

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

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

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

In addition, there can be no assurance that we will not be a PFIC in 2004 or a
later year. If, for example, the "passive income" earned by us exceeds 75% or
more of our "gross income", we will be a PFIC under the income test. Passive
income for PFIC purposes includes, among other things, gross interest,
dividends, royalties, rents and annuities. For manufacturing businesses, gross
income for PFIC purposes should be determined by reducing total sales by the
cost of goods sold. Although not free from doubt, if our cost of goods sold
exceeds our total sales by an amount greater than our passive income, such that
we are treated as if we had no gross income for PFIC purposes, we believe that
we would not be a PFIC as a result of the income test. This belief is supported
by a private letter ruling issued by the IRS to a company whose circumstances
are substantially the same as ours, although such private letter ruling would
not be binding on the IRS in determining our status. In addition, the tests for
determining PFIC status are applied annually and it is difficult to make
accurate predictions of future income and assets, which are relevant to the
determination of PFIC status.


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<PAGE>


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

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

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

F. DIVIDENDS AND PAYING AGENTS

Not applicable.

G. STATEMENTS BY EXPERTS

Not applicable.

H. DOCUMENTS ON DISPLAY

We are required to file reports and other information with the SEC under the
Securities Exchange Act of 1934 and the regulations thereunder applicable to
foreign private issuers. Reports and other information filed by us with the SEC
may be inspected and copied at the SEC's public reference facilities described
below. Although as a foreign private issuer we are not required to file periodic
information as frequently or as promptly as United States companies, we
generally do publicly announce our quarterly and year-end results promptly and
file periodic information with the SEC under cover of Form 6-K. As a foreign
private issuer, we are also exempt from the rules under the Exchange Act
prescribing the furnishing and content of proxy statements and our officers,
directors and principal shareholders are exempt from the reporting and other
provisions in Section 16 of the Exchange Act. You may review a copy of our
filings with the SEC, including any exhibits and schedules, at the SEC's public
reference facilities in Room 1024, Judiciary Plaza, 450 Fifth Street, N.W.,
Washington, D.C. 20549 and at the regional offices of the SEC located at the
Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. You may also obtain copies of such materials from the Public
Reference Section of the SEC, Room 1024, Judiciary Plaza, 450 Fifth Street,
N.W., Washington, D.C. 20549, at prescribed rates. You may call the SEC at
1-800-SEC-0330 for further information on the public reference rooms. In
addition, such information concerning our company can be inspected and copied at
the offices of the National Association of Securities Dealers, Inc., 9513 Key


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<PAGE>


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 Qualitive 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, for
the year ended December 31, 2003, a portion of our revenues were derived, and
our expenses were denominated, in other currencies. We derived approximately 50%
of revenues in U.S. dollars, 31% in Euros, 12% in Japanese Yen and 7% in British
pounds. For the year ended December 31, 2003, 78% of our expenses were
denominated in U.S. dollars, 12% in Euros, 5% in Japanese Yen and 5% in British
pounds.

Exchange differences upon translation from the functional currency of our German
subsidiary, which is the Euro, to U.S. dollars are accumulated as a separate
component of accumulated other comprehensive income under shareholders' equity.
As of December 31, 2003, accumulated other comprehensive income increased by
$1.2 million as compared to December 31, 2002. As of December 31, 2002,
accumulated other comprehensive income increased by $730,000 as compared to
December 31, 2001. 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 (expenses), net.

The fluctuation of the Euro and the other relevant functional currencies against
the U.S. dollar has had the effect of increasing or decreasing (as applicable)
reported revenues, cost of revenues and operating expenses denominated in such
foreign currencies when translated into U.S. dollars from period to period. The
following table illustrates the effect of the changes in exchange rates on our
revenues, gross profit and income (loss) from operations for the periods
indicated:


                                       69





<PAGE>


<TABLE>
<CAPTION>
                                        Year ended December 31,
                     -------------------------------------------------------------
                            2001                 2002                 2003
                     -------------------   ------------------   ------------------
                                At 2000               At 2001              At 2002
                               exchange              exchange             exchange
                      Actual   rates(1)     Actual   rates(1)    Actual   rates(1)
                     -------   --------    -------   --------   -------   --------
<S>                  <C>        <C>        <C>        <C>       <C>        <C>
Revenues             $46,613    $47,645    $49,520    $49,192   $54,725    $52,232

Gross profit          37,293     38,250     39,282     39,028    44,926     42,001

Income (loss) from
   operations        (10,312)    (9,945)    (2,200)    (2,051)    2,410      1,675
</TABLE>

(1) Based on average exchange rates during the period.

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, 2003,
there were no foreign currency forward contracts and forward exchange options
outstanding.

Equity investments

We hold equity investments in two companies whose securities are traded on the
Tel Aviv Stock Exchange, Tamir Fishman Venture Capital II Ltd. and Comsec
Information Security Ltd. As of December 31, 2003, the combined fair market
value of these investments was $1.2 million. The value of these holdings has
fluctuated and the fair market value at December 31, 2002 was $860,000.

As of December 31, 2003, we had invested approximately $5.1 million in two
related private investment funds managed by Tamir Fishman Ventures Management II
Ltd. Each of these funds invests primarily in the securities of privately-held
technology companies in Israel. In 2002, we realized an impairment charge of
$1.0 million related to these investments and we may realize additional
impairment charges in the future. We have committed to invest an additional $3.4
million in these entities prior to 2007.

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. It is our policy
to hold such investments to maturity in order to limit our exposure to interest
rate fluctuations. Due to the short and medium-term maturities of these
investments, their carrying value equals the fair value.

Item 12. Descriptions of Securities Other than Equity Securities

Not Applicable


                                       70





<PAGE>


                                    PART II

Item 13. Defaults, Dividend Arrearages and Delinquencies

None.

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

On December 16, 2003, our shareholders adopted our new Articles of Association
conforming with the Israeli Companies Law - 1999, which became effective on
February 1, 2000. For a description of how our new Articles of Association
affect the rights of our shareholders, please refer to Item 10: The Israeli
Companies Law and our new Articles of Association, which is hereby incorporated
by reference.

Item 15. CONTROLS AND PROCEDURES

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

Item 16. [Reserved]

Item 16A. Audit Committee Financial Expert

Our board of directors has determined that Mr. David Assia and Dr. Menahem
Gutterman are audit committee financial experts.

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
Ernst & Young LLP for the audit of the Company's consolidated annual financial
statements for the years ended December 31, 2003 and 2002, and fees billed for
other services rendered by Ernst & Young LLP.


                                       71





<PAGE>


<TABLE>
<CAPTION>
                          2003       2002
                        --------   --------
<S>                     <C>        <C>
Audit Fees(1)           $117,663   $136,525
Audit-Related Fees(2)   $ 57,749   $ 57,281
Tax Fees(3)             $153,522   $153,363
</TABLE>

(1)  Audit fees consist of fees for professional services rendered for the audit
     of the Company's 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 the Company's 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 service fees also include fees relating to other tax advices, tax
     consulting and planning other than for tax compliance and preparation.

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

As a foreign private issuer the Company remains exempt, until July 31, 2005,
from the NASDAQ requirement to adopt an audit committee charter. Furthermore,
the Company's audit committee was established and selected pursuant to the laws
of Israel, and therefore the Company relies on the exemptions set forth in Rule
10A with respect to its independence.

                                    PART III

Item 17. Financial Statements

Not applicable

Item 18. Financial Statements

See our Consolidated Financial Statements, beginning on page F-1.


                                       72





<PAGE>


Item 19. Exhibits

1.1  Articles of Association of the registrant, approved by shareholders on
     August 15, 1993.(1)

1.2  Articles of Association of the registrant, approved by shareholders on
     December 16, 2003. (2)

1.3  Memorandum of Association of the registrant.(1)(3)

4.1  Asset Purchase Agreement dated as of May 17, 2001, by and between Preview
     Systems Inc. and the registrant. (4)

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

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

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

4.5  Form of Indemnification Agreement between the registrant and each of the
     members of its board of directors and its officers. (2)

4.6  Convertible Loan Agreement dated as of April 29, 2004, by and between
     C-Signature Ltd. and the registrant. (2)(5)

8.1  List of subsidiaries. (2)

11.  Code of Ethics. (2)

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

12.2 Certification by Chief Executive 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. *


                                       73





<PAGE>


----------
*    Filed herewith

(1)  Incorporated by reference from our Registration Statement on Form F-1, File
     No. 33-67980, as amended, filed with the Commission on August 26, 1993.

(2)  Previously filed as an exhibit to the Original 20-F for the fiscal year
     ended December 31, 2003, and incorporated by reference herein.

(3)  English translation or summary from Hebrew original.

(4)  Incorporated by reference from our 2000 20-F filed with the Securities
     Exchange Commission on June 30, 2001.

(5)  Portions of this exhibit have been omitted pursuant to a request for
     confidential treatment.


                                       74





<PAGE>


               ALADDIN KNOWLEDGE SYSTEMS LTD. AND ITS SUBSIDIARIES

                        CONSOLIDATED FINANCIAL STATEMENTS

                             AS OF DECEMBER 31, 2003

                                 IN U.S. DOLLARS

                                      INDEX

<TABLE>
<CAPTION>
                                                                         Page
                                                                       ---------
<S>                                                                    <C>
Reports of Independent Auditors                                        F-2 - F-3

Consolidated Balance Sheets                                             F-4 -F-5

Consolidated Statements of Operations                                        F-6

Statements of Changes in Shareholders' Equity                                F-7

Consolidated Statements of Cash Flows                                  F-8 - F-9

Notes to Consolidated Financial Statements                           F-10 - F-40
</TABLE>

                                   ----------





<PAGE>


[ERNST & YOUNG LOGO]

                         REPORT OF INDEPENDENT AUDITORS

                             To the Shareholders of

                         ALADDIN KNOWLEDGE SYSTEMS LTD.

     We have audited the accompanying consolidated balance sheets of Aladdin
Knowledge Systems Ltd. ("the Company") and its subsidiaries as of December 31,
2002 and 2003, and the related consolidated statements of operations, changes in
shareholders' equity and cash flows for each of the three years in the period
ended December 31, 2003. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements, based on our audits. We did not audit the financial
statements of Aladdin Western Europe Ltd., a wholly-owned U.K. subsidiary, which
statements reflect total assets constituting 5% and 4% as of December 31, 2002
and 2003, respectively, and total revenues constituting 6%, 7% and 15% of the
related consolidated revenues for the years ended December 31, 2001, 2002 and
2003, respectively. Those statements were audited by other auditors whose report
have 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. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits and the report of other auditors provide a reasonable basis for our
opinion.

     In our opinion, based on our audits and the report of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of the Company and its
subsidiaries as of December 31, 2002 and 2003, and the consolidated results of
their operations and cash flows for each of the three years in the period ended
December 31, 2003, in conformity with U.S. generally accepted accounting
principles.

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

Tel-Aviv, Israel                                /s/ KOST FORER GABBAY & KASIERER
January 22, 2004                                A Member of Ernst & Young Global


                                      F-2





<PAGE>


                                                  [LOGO]   BLICK
                                                           ROTHENBERG
                                                           Chartered Accountants

                         REPORT OF INDEPENDENT AUDITORS

                             To the shareholders of

                           ALADDIN WESTERN EUROPE LTD

We have audited the accompanying balance sheets of Aladdin Western Europe Ltd
("the Company"), as of December 31, 2002 and 2003, and the related statements of
operations and changes in shareholders' equity and cash flows for each of the
three years in the period ended December 31, 2003. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements, based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of the Company as of December 31,
2002 and 2003 and the results of their operations and cash flows for each of the
three years in the period ended December 31, 2003, in conformity with U.S.
generally accepted accounting principles.

/s/ BLICK ROTHENBERG
BLICK ROTHENBERG                                                    12 York Gate
Chartered Accountants                                              Regent's Park
Registered Auditors                                                       London
                                                                        NW I 4QS

29 March 2004

                                      F-3



<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
--------------------------------------------------------------------------------
U.S. dollars in thousands

<TABLE>
<CAPTION>
                                                                                  December 31,
                                                                               -----------------
                                                                                 2002      2003
                                                                               -------   -------
<S>                                                                            <C>       <C>
   ASSETS

CURRENT ASSETS:
   Cash and cash equivalents                                                   $14,235   $18,287
   Marketable securities (Note 3)                                                  860     1,229
   Trade receivables (net of allowance for doubtful accounts - $ 991 in 2002
      and $ 972 in 2003)                                                         8,094     9,766
   Other accounts receivable and prepaid expenses (Note 4)                       2,177     2,223
   Deferred income taxes (Note 13 g)                                               469       669
   Inventories (Note 5)                                                          6,269     5,795
                                                                               -------   -------
Total current assets                                                            32,104    37,969
                                                                               -------   -------

LONG-TERM INVESTMENTS:
   Investment in affiliate (Note 6)                                                 --        --
   Investment in other company (Note 7)                                          2,252     3,962
   Severance pay fund                                                            1,957     2,322
                                                                               -------   -------
Total long-term investments                                                      4,209     6,284
                                                                               -------   -------

PROPERTY AND EQUIPMENT, NET (Note 8)                                             3,478     2,447
                                                                               -------   -------

OTHER ASSETS, NET
   Intangible assets, net (Note 9)                                                 752       531
   Goodwill (Note 10)                                                            7,281     7,281
   Deferred income taxes (Note 13 g)                                               715       956
                                                                               -------   -------
Total other assets                                                               8,748     8,768
                                                                               -------   -------
Total assets                                                                   $48,539   $55,468
                                                                               =======   =======
</TABLE>

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


                                      F-4





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
--------------------------------------------------------------------------------
U.S. dollars in thousands, except share data

<TABLE>
<CAPTION>
                                                                    December 31,
                                                                 -----------------
                                                                   2002      2003
                                                                 -------   -------
<S>                                                              <C>       <C>
      LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
   Trade payables                                                $ 2,398   $ 2,306
   Deferred revenues                                               2,323     3,415
   Accrued expenses and other accounts payable (Note 11)           4,719     5,623
                                                                 -------   -------
Total current liabilities                                          9,440    11,344
                                                                 -------   -------
ACCRUED SEVERANCE PAY                                              2,772     3,168
                                                                 -------   -------
COMMITMENTS AND CONTINGENT LIABILITIES (Note 12)

SHAREHOLDERS' EQUITY (Note 14):
   Share capital: Ordinary shares of NIS 0.01 par value
      - Authorized: 15,000,000 shares at December 31, 2002
      and 2003; Issued: 11,477,922 shares at December 31, 2002
      and 2003; Outstanding: 11,253,822 and 11,405,302 shares
      at December 31, 2002 and 2003, respectively                     37        37
   Additional paid-in capital                                     36,147    36,147
   Treasury shares                                                (1,164)     (377)
   Accumulated other comprehensive loss                           (4,529)   (3,092)
   Retained earnings                                               5,836     8,241
                                                                 -------   -------
Total shareholders' equity                                        36,327    40,956
                                                                 -------   -------
Total liabilities and shareholders' equity                       $48,539   $55,468
                                                                 =======   =======
</TABLE>

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


                                       F-5





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
--------------------------------------------------------------------------------
U.S. dollars in thousands, except per share data

<TABLE>
<CAPTION>
                                                           Year ended December 31,
                                                        ----------------------------
                                                          2001       2002      2003
                                                        --------   -------   -------
<S>                                                     <C>        <C>       <C>
Revenues (Note 16):
   Software security                                    $ 38,421   $40,093   $43,521
   Enterprise security                                     8,192     9,427    11,204
                                                        --------   -------   -------
Total revenues                                            46,613    49,520    54,725
                                                        --------   -------   -------
Cost of revenues:
   Software security                                       7,753     8,405     7,995
   Enterprise security                                     1,567     1,833     1,804
                                                        --------   -------   -------
Total cost of revenues                                     9,320    10,238     9,799
                                                        --------   -------   -------
Gross profit                                              37,293    39,282    44,926
                                                        --------   -------   -------
Operating expenses:
   Research and development (Note 1c)                     11,043    12,245    12,759
   Selling and marketing (Note 1c)                        22,474    21,990    22,012
   General and administrative (Note 1c)                    8,877     7,247     7,745
   Impairment of intangible assets (Note 2)                5,211        --        --
                                                        --------   -------   -------
Total operating expenses                                  47,605    41,482    42,516
                                                        --------   -------   -------
Operating income (loss)                                  (10,312)   (2,200)    2,410
Financial income (expenses), net (Note 17a)                 (410)      491       480
Other expenses, net (Note 17b)                            (3,372)     (932)       (5)
                                                        --------   -------   -------
Income (loss) before taxes on income                     (14,094)   (2,641)    2,885
Taxes on income (Note 13)                                   (347)    2,738        49
                                                        --------   -------   -------
Income (loss) before equity in losses of an affiliate    (13,747)   (5,379)    2,836
Equity in losses of an affiliate                          (1,168)   (1,257)     (100)
                                                        --------   -------   -------
Net income (loss)                                       $(14,915)  $(6,636)  $ 2,736
                                                        ========   =======   =======
Net earnings (loss) per share (Note 17c):
   Basic                                                $  (1.32)  $ (0.59)  $  0.24
                                                        ========   =======   =======
   Diluted                                              $  (1.32)  $ (0.59)  $  0.23
                                                        ========   =======   =======
</TABLE>

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


                                       F-6





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
--------------------------------------------------------------------------------
U.S. dollars in thousands

<TABLE>
<CAPTION>
                                                                                              Accumulated
                                                                     Additional                  other
                                                            Share      paid-in    Treasury   comprehensive
                                                           capital     capital     shares        loss
                                                          --------   ----------   --------   -------------
<S>                                                          <C>       <C>        <C>          <C>
Balance as of January 1, 2001                                $37       $36,147    $  (903)     $  (3,972)
   Purchase of Treasury shares                                --            --       (261)            --
   Other comprehensive loss:
   Unrealized losses on available-for-sale marketable
      securities, net of taxes                                --            --         --         (1,302)
   Less - reclassification of adjustment of other than
      temporary decrease in value of available-for-sale
      marketable securities                                   --            --         --          1,004
   Foreign currency translation adjustments                   --            --         --           (593)
   Total other comprehensive loss                             --            --         --             --
   Net loss                                                   --            --         --             --
                                                             ---       -------    -------      ---------
   Total comprehensive loss

Balance as of December 31, 2001                               37        36,147     (1,164)        (4,863)
   Other comprehensive loss:
   Unrealized losses on available-for-sale marketable
      securities, net of taxes                                --            --         --           (645)
   Less - reclassification of adjustment of other than
      temporary decrease in value of available-for-sale
      marketable securities                                   --            --         --            250
   Foreign currency translation adjustments                   --            --         --            729
   Total other comprehensive income                           --            --         --             --
   Net loss                                                   --            --         --             --
                                                             ---       -------    -------      ---------
   Total comprehensive loss

Balance as of December 31, 2002                               37        36,147     (1,164)        (4,529)
   Exercise of stock options                                  --            --        787             --
   Other comprehensive income:
   Unrealized gain on available-for-sale marketable
   securities, net
      of taxes                                                --            --         --            260
   Foreign currency translation adjustments                   --            --         --          1,177
   Total other comprehensive income                           --            --         --             --
   Net income                                                 --            --         --             --
                                                             ---       -------    -------      ---------
   Total comprehensive income

Balance as of December 31, 2003                              $37       $36,147    $  (377)     $*)(3,092)
                                                             ===       =======    =======      =========

<CAPTION>

                                                                         Total           Total
                                                          Retained   comprehensive   shareholders'
                                                          earnings   income (loss)      equity
                                                          --------   -------------   -------------
<S>                                                       <C>          <C>              <C>
Balance as of January 1, 2001                             $ 27,387                      $58,696
   Purchase of Treasury shares                                  --                         (261)
   Other comprehensive loss:
   Unrealized losses on available-for-sale marketable
      securities, net of taxes                                  --     $ (1,302)         (1,302)
   Less - reclassification of adjustment of other than
      temporary decrease in value of available-for-sale
      marketable securities                                     --        1,004           1,004
   Foreign currency translation adjustments                     --         (593)           (593)
                                                                       --------
   Total other comprehensive loss                               --         (891)             --
   Net loss                                                (14,915)     (14,915)        (14,915)
                                                          --------     --------        --------
   Total comprehensive loss                                            $(15,806)
                                                                       ========

Balance as of December 31, 2001                             12,472                       42,629
   Other comprehensive loss:
   Unrealized losses on available-for-sale marketable
      securities, net of taxes                                  --     $   (645)           (645)
   Less - reclassification of adjustment of other than
      temporary decrease in value of available-for-sale
      marketable securities                                     --          250             250
   Foreign currency translation adjustments                     --          729             729
                                                                       --------        --------
   Total other comprehensive income                             --          334              --
   Net loss                                                 (6,636)      (6,636)         (6,636)
                                                          --------     --------        --------
   Total comprehensive loss                                            $ (6,302)
                                                                       ========

Balance as of December 31, 2002                              5,836                       36,327
   Exercise of stock options                                  (331)                         456
   Other comprehensive income:
   Unrealized gain on available-for-sale marketable
      securities, net of taxes                                  --     $    260             260
   Foreign currency translation adjustments                     --        1,177           1,177
                                                                       --------
   Total other comprehensive income                             --        1,437              --
   Net income                                                2,736        2,736           2,736
                                                          --------     --------        --------
   Total comprehensive income                                          $  4,173
                                                                       ========

Balance as of December 31, 2003                           $  8,241                     $ 40,956
                                                          ========                     ========
</TABLE>

*)   Composed as follows:

<TABLE>
<S>                                                         <C>
     Accumulated unrealized gains from available-for-sale
        marketable securities, net of taxes                 $   193
     Accumulated foreign currency translation adjustments    (3,285)
                                                            -------
     Accumulated other comprehensive loss                   $(3,092)
                                                            =======
</TABLE>

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


                                       F-7





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
--------------------------------------------------------------------------------
U.S. dollars in thousands

<TABLE>
<CAPTION>
                                                                        Year ended December 31,
                                                                     ----------------------------
                                                                       2001       2002      2003
                                                                     --------   -------   -------
<S>                                                                  <C>        <C>       <C>
Cash flows from operating activities:

   Net income (loss)                                                 $(14,915)  $(6,636)  $ 2,736
   Adjustments required to reconcile net income (loss) to net cash
      provided by (used in) operating activities:
      Depreciation and amortization                                     4,415     2,310     2,110
      Impairment of intangible assets                                   5,211        --        --
      Impairment of investment in FAST                                  3,350        --        --
      Equity in losses of an affiliate                                  1,168     1,257       100
      Impairment of investment in other company                            --     1,038        --
      Increase in accrued severance pay, net                              196        28        31
      Impairment of available-for-sale marketable securities            1,004       391        --
      Deferred income taxes, net                                         (486)    2,500      (414)
      Decrease (increase) in trade receivables                              3       109    (1,450)
      Decrease (increase) in inventories                                 (982)    1,383     1,033
      Decrease in other accounts receivable and prepaid expenses          150       984        72
      Increase (decrease) in trade payables                              (686)      304      (114)
      Increase in deferred revenues                                       365       297     1,092
      Increase (decrease) in accrued expenses and other accounts
         payable                                                       (3,777)      317       723
      Other                                                               (43)      (35)      (15)
                                                                     --------   -------   -------
Net cash provided by (used in) operating activities                    (5,027)    4,247     5,904
                                                                     --------   -------   -------

Cash flows from investing activities:

   Proceeds from short-term bank deposits                                 500        --        --
   Proceeds from sale of available-for-sale marketable securities      11,004        --        --
   Investment in shares and long-term loan of an affiliate               (650)     (987)     (100)
   Proceeds from long-term loans to an affiliate                          250        --        --
   Purchase of property and equipment                                  (1,235)   (1,141)     (913)
   Proceeds from sale of property and equipment                            31        74       139
   Purchase of intangible assets                                           --       (16)       --
   Investment in other company                                         (1,241)     (444)   (1,710)
   Payment for the purchase of Preview (1)                             (5,239)       --        --
                                                                     --------   -------   -------
Net cash provided by (used in) investing activities                     3,420    (2,514)   (2,584)
                                                                     --------   -------   -------
</TABLE>

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


                                       F-8





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
--------------------------------------------------------------------------------
U.S. dollars in thousands

<TABLE>
<CAPTION>
                                                                           Year ended December 31,
                                                                        ---------------------------
                                                                          2001      2002      2003
                                                                        -------   -------   -------
<S>                                                                     <C>       <C>       <C>
Cash flows from financing activities:

   Proceeds from exercise of options                                         --        --       456
   Purchase of Treasury shares                                             (261)       --        --
                                                                        -------   -------   -------

Net cash provided by (used in) financing activities                        (261)       --       456
                                                                        -------   -------   -------

Effect of exchange rate on cash and cash equivalents                       (271)      296       276
                                                                        -------   -------   -------

Increase (decrease) in cash and cash equivalents                         (2,139)    2,029     4,052
Cash and cash equivalents at the beginning of the year                   14,345    12,206    14,235
                                                                        -------   -------   -------

Cash and cash equivalents at the end of the year                        $12,206   $14,235   $18,287
                                                                        =======   =======   =======
Supplemental disclosure:

   Income taxes paid during the year                                    $ 3,200   $   419   $   490
                                                                        =======   =======   =======
Non-cash activities:

   Conversion of long-term note receivable to an investment in an
      affiliate (Note 15)                                               $ 3,350   $    --   $    --
                                                                        =======   =======   =======

   Waiver of employee loans in exchange for investment in Tamir
      Fishman Venture II Ltd.                                           $    --   $   600   $    --
                                                                        =======   =======   =======

   Conversion of balance in trade receivable due from an affiliate to
      long-term loan to an affiliate                                    $    --   $   244   $    --
                                                                        =======   =======   =======
</TABLE>

(1)  Payment for purchase of Preview (see Note 1b):

     Fair value of assets acquired and liabilities assumed at the date of
     acquisition:

<TABLE>
<S>                                                                     <C>
     Trade receivables                                                  $  339
     Property and equipment                                                662
     Accrued expenses in respect of acquisition costs                     (194)
     Intangible assets - current technology                              1,039
     Goodwill                                                            3,393
                                                                        ------
                                                                        $5,239
                                                                        ======
</TABLE>

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


                                       F-9





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 1:- GENERAL

          a.   Aladdin Knowledge Systems Ltd. and its wholly-owned subsidiaries
               (collectively, "the Company" or "Aladdin") is engaged in software
               security (or Digital Rights Management, or DRM) and enterprise
               security.

               Within software security, Aladdin develops and markets the
               following products: HASP and Hardlock, hardware-based software
               security systems, Privilege SCP, a software marketing, licensing
               and distribution platform. Both the software and the hardware
               products protect our customers' software against unauthorized
               copying and illegal use.

               Within enterprise security, Aladdin develops and markets the
               USB-based eToken device for user authentication and e-commerce
               security and the eSafe line of content security solutions that
               protect PCs and networks against malicious, inappropriate and
               non-productive Internet-born content.

               The Company is dependent upon sole source suppliers for certain
               key components used in its products. Although there is a limited
               number of manufacturers of these particular components, the
               Company's management believes that other suppliers could provide
               similar components at comparable terms. A change in suppliers,
               however, could cause a delay in manufacturing and a possible loss
               of sales, which could adversely effect the operating results of
               the Company and its financial position.

          b.   Acquisition of Preview Systems Inc. ("Preview"):

               On July 19, 2001, the Company acquired certain assets and assumed
               certain liabilities of Preview Systems Inc. ("Preview"). Pursuant
               to the terms of the acquisition agreement, the Company paid $
               5,239 in cash, out of which $ 327 was in respect of acquisition
               costs.

               Preview was engaged in the business of providing an
               Internet-based infrastructure solution, creating an end-user
               electronic distribution chain.

               The operations of Preview are included in the consolidated
               financial statements from the date of acquisition.

               The acquisition was accounted for by the purchase method of
               accounting, in accordance with Statement of Financial Accounting
               Standards No. 141 "Business Combination" ("SFAS No. 141"), and
               accordingly, the purchase price has been allocated to the assets
               acquired and the liabilities assumed based on their estimated
               fair value at the date of acquisition. The excess of the purchase
               price over the estimated fair value of the net assets acquired
               has been recorded as goodwill.


                                       F-10





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 1:- GENERAL (Cont.)

               The following table summarizes the estimated fair value of assets
               acquired at the date of acquisition:

<TABLE>
<S>                                                                      <C>
               Trade receivables                                         $  339
               Property and equipment                                       662
               Goodwill                                                   3,393
               Current Technology                                         1,039
                                                                         ------
               Net assets acquired                                       $5,433
                                                                         ======
</TABLE>

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

          c.   Restructuring charges:

               As a result of the downturn in global economic conditions, the
               decline in overall business levels and the related impact on the
               Company's operations, the Company and its subsidiaries
               implemented during 2002 a worldwide restructuring and cost
               reduction plan. In connection with the 2002 restructuring plan,
               Emerging Issues Task Force 94-3 "Liability Recognition for
               Certain Employee Termination Benefits and Other Cost to Exit an
               Activity (Including Certain Cost in Restructuring)" and Staff
               Accounting Bulletin No. 100 "Restructuring and Impairment
               Charges" were applied. The Company and its subsidiaries incurred
               expenses of $ 1,123, out of which $ 467 were included in research
               and development expenses, $ 500 in selling and marketing expenses
               and $ 156 in general and administrative expenses.

               The major components of restructuring charges were as follows:

<TABLE>
<CAPTION>
                                                                     Year ended
                                                                    December 31,
                                                                        2002
                                                                    ------------
<S>                                                                    <C>
               Employee termination benefits                           $  603
               Facilities closures                                        166
               Consulting fees                                            160
               Other                                                      194
                                                                       ------
                                                                       $1,123
                                                                       ======
</TABLE>


                                      F-11





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES

          The consolidated financial statements have been prepared in accordance
          with accounting principles generally accepted in the United States
          ("U.S. GAAP").

          Use of estimates:

          The preparation of financial statements in conformity with generally
          accepted accounting principles requires management to make estimates
          and assumptions that affect the amounts reported in the financial
          statements and accompanying notes. Actual results could differ from
          those estimates.

          Financial statements in United States dollars:

          1.   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 and an entity
               reported using the equity method of accounting, 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 has 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 equivalents:

          Cash equivalents include short-term, highly liquid investments that
          are readily convertible to cash with maturities of three months or
          less at the date acquired.


                                     F-12





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

          Marketable securities:

          Management determines the classification of its investments in
          marketable equity securities at the time of purchase and reevaluates
          such designations as of each balance sheet date. At December 31, 2003
          and 2002, all marketable securities covered by Statement of Financial
          Accounting Standard No. 115 "Accounting for Certain Investments in
          Debt and Equity Securities" were designated as available-for-sale.

          Accordingly, these securities are stated at fair value, with
          unrealized gains and losses reported in accumulated other
          comprehensive loss, a separate component of shareholders' equity, net
          of taxes. Realized gains and losses on sales of investments, and
          impairment of investments, as determined on a specific identification
          basis, are included in the consolidated statement of operations.

          Following SEC Staff Accounting Bulletin No. 59, management evaluates
          each period whether declines in the market value of it's securities
          are other than temporary. Where such declines are determined to be
          other than temporary, those securities are written-down to their
          current market value with the amount of the write-down included in
          financial expenses (see Note 3 and 17a).

          Investment in an affiliate:

          The investment in an affiliate over which the Company can exercise
          significant influence (generally, entities in which the Company holds
          20% to 50% of voting rights) is presented using the equity method of
          accounting, and in accordance with EITF 99-10, "Percentage Used to
          Determine the Amount of Equity Method Losses", which requires that an
          investor recognizes equity method losses based on it's ownership of
          all investee securities held by the investor and the changes in the
          investor's claim on the investee's book value. The Company generally
          discontinues applying the equity method when its investment (including
          advances and loans) is reduced to zero and it has not guaranteed
          obligations of the affiliate or otherwise committed to provide further
          financial support to the affiliate.

          The investments are reviewed for impairment whenever events or changes
          in circumstances indicate that the carrying amount of an investment
          may not be recoverable in accordance with Accounting Principle Board
          Opinion No.18 "The Equity Method of Accounting for Investments in
          Common Stock", ("APB No.18").

          As of December 31, 2002, based on management's most recent analyses,
          impairment losses have been identified in the amount of $ 291, and
          have been included in equity losses of an affiliate (see Note 6).


                                      F-13





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

          Investment in other company:

          The investment in this company is stated at cost, since the Company
          does not have the ability to exercise significant influence over
          operating and financial policies of the investee. The Company's
          investment in the other company is reviewed for impairment whenever
          events or changes in circumstances indicate that the carrying amount
          of an investment may not be recoverable, in accordance with APB No.18.
          During 2001 and 2002, based on management's most recent analyses,
          impairment losses have been identified in the amount of $ 1,038 and $
          3,350, respectively (see Note 7 and Note 15).

          Inventories:

          Inventories are stated at the lower of cost or market value. Inventory
          write-offs are provided to cover risks arising from slow-moving items,
          technological obsolescence, excess inventories and for market prices
          lower than cost.

          Cost is determined as follows:

          Raw materials, parts and supplies - using the moving average cost
          method.

          Work-in-progress and finished products - recorded on the basis of
          direct manufacturing costs, with the addition of allocable indirect
          manufacturing costs.

          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:

<TABLE>
<CAPTION>
                                                            %
                                               --------------------------
<S>                                            <C>
          Computers and peripheral equipment             15 - 33
          Office furniture and equipment                  6 - 20
          Motor vehicles                                      15
          Leasehold improvements               Over the term of the lease
</TABLE>

          Intangible assets:

          Intangible assets acquired in a business combination for which date is
          on or after July 1, 2001, 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 Statement of Financial Accounting Standards No. 142
          "Goodwill and Other Intangible Assets", ("SFAS No. 142").

          Current technology is amortized using the straight-line method over
          its estimated useful life which is five years.


                                      F-14





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

          Impairment of long-lived assets:

          The long-lived assets of the Company and its subsidiaries and certain
          identifiable intangibles are reviewed for impairment in accordance
          with Statement of Financial Accounting Standard No.144 "Accounting for
          the Impairment or Disposal of Long-Lived Assets"("SFAS No.144") and in
          accordance with Statement of Financial Accounting Standard No. 121
          "Accounting for the Impairment of Long-Lived Assets and for the
          Long-lived Assets to be Disposed Of" ("SFAS No. 121"). SFAS No. 121
          related only to 2001. According to SFAS No. 121 and SFAS No. 144,
          whenever events or changes in circumstances indicate that the carrying
          amount of an asset would not be recoverable. Recoverability of assets
          to be held and used is measured by a comparison of the carrying amount
          of an asset to the future undiscounted cash flows expected to be
          generated by the assets. If such assets are considered to be impaired,
          the impairment to be recognized is measured by the amount by which the
          carrying amount of the assets exceeds the fair value of the assets. As
          of December 31, 2003, no impairment losses have been identified.

          Goodwill:

          Goodwill represents excess of the costs over the fair value of net
          assets of businesses acquired. Under "SFAS No. 142", goodwill acquired
          in a business combination on or after July 1, 2001, is not amortized.
          Goodwill that arose from acquisitions completed before July 1, 2001
          was amortized until December 31, 2001, on a straight-line basis over 5
          years.

          SFAS No.142 requires goodwill to be tested for impairment on adoption
          as of January 1, 2002 and at least annually thereafter or between
          annual tests in certain circumstances, and written down when impaired,
          rather than being amortized as previous accounting standards required.
          Goodwill is tested for impairment by comparing the fair value of the
          reporting unit with its carrying value. Fair value is determined using
          the income approach. Significant estimates used in the methodologies
          included estimates of future cash flows and estimates of discount
          rate. During December 2002, the Company performed the required annual
          impairment tests of goodwill's fair value. Based on management
          projections, and expected future discounted operating cash flows, no
          indication of goodwill impairment was identified. In 2003, as part of
          the annual impairment test, the Company carried forward the
          determination of the reporting unit's fair value, because the assets
          and liabilities that comprise the reporting unit have not changed
          significantly since the most recent fair value determination. As a
          result no impairment losses has been identified as of December 31,
          2003.

          In the third quarter of 2001, management considered current and
          anticipated industry conditions, recent changes in its business
          strategies and current and anticipated operating results. As a result
          of the above conditions, management conducted an evaluation of the
          carrying value and amortization periods of the Company's recorded
          intangible assets and goodwill. The evaluation resulted in a goodwill
          impairment charge of $ 5,211. The evaluation of the carrying value was
          in accordance to SFAS No. 121.


                                      F-15





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

          Income taxes:

          The Company and its subsidiaries account for income taxes in
          accordance with Statement of Financial Accounting Standards No. 109,
          "Accounting for Income Taxes" ("SFAS No. 109"). This Statement
          prescribes the use of the liability method whereby deferred tax assets
          and liability account balances are determined based on the differences
          between financial reporting and tax bases of assets and liabilities
          and are measured using the enacted tax rates and laws that will be in
          effect when the differences are expected to reverse. The Company and
          its subsidiaries provide a valuation allowance, if necessary, to
          reduce deferred tax assets to their estimated realizable value.

          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, Hardlock and eToken) and from licensing the right to use its
          software products (eSafe and Privilege) which includes maintenance and
          support.

          The hardware based products contain an insignificant embedded software
          element which is incidental to the product as a whole since the
          embedded software is not marketed or sold separately and is used
          solely in connection with the operation of the hardware products.

          The Company generates revenues from its products directly to end-users
          and indirectly, mostly through value-added resellers, original
          equipment manufacturers and independent distributors (all of whom are
          considered end-users). Other than pricing terms which may differ due
          to the different volume of purchases between resellers, manufacturers
          and distributors and end-users, there are no material differences in
          the terms and arrangements involving direct and indirect customers.
          All of the Company's products sold through agreements with value-added
          resellers, original equipment manufacturers and independent
          distributors are non-exchangeable, non-refundable, nonreturnable and
          without any rights of price protection or stock rotation. Accordingly,
          the Company considers them all 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. 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.


                                      F-16





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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


NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

          Persuasive evidence of an arrangement exists. The Company determines
          that persuasive evidence of an arrangement exists with respect to a
          customer when it has a written contract, which is signed by both the
          Company and the customer or a purchase order from the customer
          (documentation is dependent on the business practice for each type of
          customer).

          Delivery has occurred. The Company's hardware and software products
          may be physically delivered to the customer, or with regard to
          software products, the products may be electronically delivered to the
          customer. The Company determines that delivery of hardware products
          has occurred when the title and risk of loss have been transferred to
          the customer. In connection with delivery of software products, the
          Company determines that delivery has occurred upon shipment of the
          software or, when the software is made available to the customer
          through electronic delivery, when the customer has been provided with
          access codes that allow the customer to take immediate possession of
          the software.

          The fee is fixed or determinable. Generally, payments that extend
          beyond 30 days from the contract date but that are due within six
          months are deemed to be fixed or determinable based on the Company's
          successful collection history on such arrangements. Arrangements with
          payment terms extending beyond these customary payment terms are
          considered not to be fixed or determinable, and revenue from such
          arrangements is recognized as payments become due from the customer,
          provided that all other revenue recognition criteria have been met.

          Collectibility is probable. The Company determines whether
          collectibility is probable on a case-by case basis. When assessing
          probability of collection, the Company considers the customer's
          financial condition, the number of years in business with the customer
          and the history of collection. If the Company determines from the
          outset that collectibility is not probable based upon its review
          process, revenue is recognized as payments are received.

          With regard to software arrangements involving multiple elements such
          as software product and maintenance and support, the Company has
          adopted Statement of Position No. 98-9, "Modification of SOP No. 97-2,
          Software Revenue Recognition with Respect to Certain Transactions"
          ("SOP No. 98-9"). According to SOP No. 98-9, revenues should be
          allocated to the different elements in the arrangement under the
          "residual method" when Vendor Specific Objective Evidence ("VSOE") of
          fair value exists for all undelivered elements and no VSOE exists for
          the delivered elements. Under the residual method, at the outset of
          the arrangement with the customer, the Company defers revenue for the
          fair value of its undelivered elements (maintenance and support) and
          recognizes revenue for the remainder of the arrangement fee
          attributable to the elements initially delivered in the arrangement
          (software product) when the basic criteria in SOP No. 97-2 have been
          met. Any discount in the arrangement is allocated to the delivered
          element. Maintenance and support revenue is deferred and recognized on
          a straight-line basis over the term of the maintenance and support
          agreement. The VSOE of fair value of the undelivered elements
          (maintenance and support) is determined based on the price charged for
          the undelivered element when sold separately. Time-based licenses
          include maintenance and on-going support. VSOE of fair value does not
          exist for the related support arrangement as maintenance is not priced
          or offered separately for such arrangements. In these cases, the
          Company recognizes the license and maintenance revenue ratably over
          the period of each arrangement.


                                      F-17





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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


NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

          Deferred revenues include unearned amounts received from maintenance
          and support contracts and amounts received from customers but not
          recognized as revenues.

          Severance pay:

          The Company's liability for severance pay is calculated pursuant to
          Israel's Severance Pay Law, based on the most recent salary of the
          Israeli employees, multiplied by the number of years of employment as
          of balance sheet date. Employees are entitled to one month's salary
          for each year of employment, or a portion thereof. The Company's
          liability for all of its employees in Israel is fully provided by
          monthly deposits with severance pay funds, insurance policies and by
          an accrual. The value of those policies is recorded as an asset in the
          Company's balance sheet.

          The deposited funds include profits accumulated up to the balance
          sheet date. The deposited funds may be withdrawn, only upon
          fulfillment of the obligation pursuant to Israel's Severance Pay Law
          or labor agreements. The value of the deposited funds is based on the
          cash surrendered value of these policies, and includes immaterial
          profits.

          Severance pay expenses for the years ended December 31, 2001, 2002 and
          2003, amounted to $ 991, $ 1,468 and $ 1,411, respectively.


                                      F-18





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

          Advertising expenses:

          Advertising expenses are charged to the statement of operations, as
          incurred. Advertising expenses for the years ended December 31, 2001,
          2002 and 2003 were $ 3,467, $ 3,717 and $ 2,773, respectively.

          Concentrations of credit risks:

          Financial instruments that potentially subject the Group to
          concentrations of credit risk consist principally of cash and cash
          equivalents and trade receivables.

          The majority of the Company's cash and cash equivalents is invested in
          U.S. dollar deposits with major banks in Israel, the United States,
          Japan, Germany, the Netherlands, the U.K. 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. However, management
          believes that such financial institutions are financially sound.

          The trade receivables of the Company and its subsidiaries are derived
          from sales to customers located primarily in the U.S., Europe, South
          East Asia and Israel. The Company performs ongoing credit evaluations
          of its customers and, to date, has not experienced any material
          losses. An allowance for doubtful accounts is determined with respect
          to those amounts that the Company has determined to be doubtful of
          collection, on a specific account basis.

          Basic and diluted net earnings (loss) per share:

          Basic net earnings (loss) per share are computed based on the weighted
          average number of Ordinary shares outstanding during each year.
          Diluted net earnings (loss) per share are computed based on the
          weighted average number of Ordinary shares outstanding during each
          year, plus dilutive potential Ordinary shares considered outstanding
          during the year, in accordance with Statement of Financial Accounting
          Standard No. 128, "Earnings Per Share" ("SFAS No. 128").

          All outstanding stock options have been excluded from the calculation
          of the diluted net earnings (loss) per Ordinary shares for the periods
          ending December 31, 2001 and 2002, because all such securities are
          anti-dilutive. The total weighted average number of shares related to
          the outstanding options excluded from the calculations of diluted net
          loss per share was 1,423,041, 1,543,902 and 0 for the years ended
          December 31, 2001, 2002 and 2003, respectively.


                                      F-19





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands, except earnings (loss) per share data

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

          Accounting for stock-based compensation:

          The Company has elected to follow Accounting Principles Board Opinion
          No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25") and
          FASB Interpretation No. 44 "Accounting for Certain Transactions
          Involving Stock Compensation", in accounting for its employee stock
          option plans. Under APB No. 25, when the exercise price of an employee
          stock options is equivalent to or above the market price of the
          underlying shares on the date of grant no compensation expense is
          recognized.

          The Company adopted the disclosure provisions of Statement of
          Financial Accounting Standards No. 148, "Accounting for Stock-Based
          Compensation - Transition and Disclosure" ("SFAS No. 148"), which
          amended certain provisions of Statement of Financial Accounting
          Standard No. 123 ("SFAS No. 123") to provide alternative methods of
          transition for an entity that voluntarily changes to the fair value
          based method of accounting for stock-based employee compensation,
          effective as of the beginning of the fiscal year. The Company
          continues to apply the provisions of APB No. 25, in accounting for
          stock-based compensation.

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

<TABLE>
<CAPTION>
                                                    2001      2002       2003
                                                  -------   -------   ---------
<S>                                               <C>       <C>       <C>
          Dividend yield                                0%        0%          0%
          Expected volatility                        53.6%     25.8%       80.2%
          Risk-free interest                            2%      1.5%        2.5%
          Expected life of up to                   5 years   5 years   4.5 years
</TABLE>

          Pro forma information under SFAS No. 123:

<TABLE>
<CAPTION>
                                                                  Year ended December 31,
                                                                ---------------------------
                                                                  2001       2002     2003
                                                                --------   -------   ------
<S>                                                             <C>        <C>       <C>
          Net income (loss) available to Ordinary shares - as
             reported                                           $(14,915)  $(6,636)   2,736
          Deduct: stock-based employee compensation - fair
             value                                                   491       211      542
                                                                --------   -------   ------
          Pro forma:
             Net income (loss)                                  $(15,406)  $(6,847)  $2,194
                                                                ========   =======   ======
             Earnings per share:

             Earnings (loss) as reported                        $  (1.32)  $ (0.59)  $ 0.24
                                                                ========   =======   ======
             Diluted earnings (loss) as reported                $  (1.32)  $ (0.59)  $ 0.23
                                                                ========   =======   ======
             Pro forma basic earnings (loss)                    $  (1.37)  $ (0.61)  $ 0.19
                                                                ========   =======   ======
             Pro forma diluted earnings (loss)                  $  (1.37)  $ (0.61)  $ 0.18
                                                                ========   =======   ======
</TABLE>


                                      F-20





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands, except earnings (loss) 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:

          The carrying amount reported in the balance sheet for cash and cash
          equivalents, trade receivables, other accounts receivable, trade
          payables and other accounts payable approximate their fair value due
          to the short-term maturities of such instruments.

          The fair value for marketable securities are based on quoted market
          price (see Note 3).

          Treasury Shares:

          The Company repurchases its Ordinary shares from time to time on the
          open market and holds such shares as Treasury shares. The Company
          presents the cost to repurchase Treasury shares as a reduction in
          shareholders' equity.

          Derivative instruments:

          Financial Accounting Standards Board Statement No. 133, "Accounting
          for Derivative Instruments and Hedging Activities" ("SFAS No. 133"),
          requires companies to recognize all of its derivative instruments as
          either assets or liabilities in the statement of financial position at
          fair value. The accounting for changes in the fair value (i.e., gains
          or losses) of a derivative instrument depends on whether it has been
          designated and qualifies as part of a hedging relationship and
          further, on the type of hedging relationship.

          For those derivative instruments that are designated and qualify as
          hedging instruments, a company must designate the hedging instrument,
          based upon the exposure being hedged, as a fair value hedge, cash flow
          hedge or a hedge of a net investment in a foreign operation.

          For derivative instruments that are designated and qualify as a fair
          value hedge (i.e., hedging the exposure to changes in the fair value
          of an asset or a liability or an identified portion thereof that is
          attributable to a particular risk), the gain or loss on the derivative
          instrument as well as the offsetting loss or gain on the hedged item
          attributable to the hedged risk are recognized in current earnings
          during the period of the change in fair values. 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 income and reclassified into
          earnings in the same period or periods during which the hedged
          transaction affects earnings. The remaining gain or loss on the
          derivative instrument in excess of the cumulative change in the
          present value of future cash flows of the hedged item, if any, is
          recognized in current earnings during the period of change.


                                      F-21





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

          The Company has instituted a foreign currency cash flow hedging
          program to hedge against the risk of overall changes in cash flows
          resulting from forecasted foreign currency sales collections during
          the year. The Company hedges portions of its forecasted expenses
          denominated in Euro and Japanese Yen with put and call options (zero -
          cost collar). These option contracts are designated as cash flow
          hedges, as defined by SFAS No. 133 and are all effective.

          The Company recognized losses of $ 793 during the year ended December
          31, 2003. All amounts have been deducted from revenues in the
          statement of operations.

          Reclassification:

          Certain amounts from prior years have been reclassified to conform to
          the current period presentation.

          The reclassification had no effect on previously reported net loss,
          shareholders' equity or cash flows.

          Impact of recently Issued Accounting Standards:

          In May 2003, the Emerging Issues Task Force ("EITF") reached a
          consensus on Issue No. 00-21, "Revenue Arrangements with Multiple
          Deliverables". EITF Issue No. 00-21 provides guidance on how to
          account for arrangements that involve the delivery or performance of
          multiple products, services and/or rights to use assets. The
          provisions of EITF Issue No. 00-21 applied to revenue arrangements
          entered into in fiscal periods beginning after June 15, 2003.
          Additionally, companies will be permitted to apply the consensus
          guidance in this issue to all existing arrangements as the cumulative
          effect of a change in accounting principle in accordance with APB
          Opinion No. 20, "Accounting Changes". The adoption of EITF Issue No.
          00-21 did not have a material impact upon the Company's financial
          position, cash flows or results of operations.

          In January 2003, the FASB issued Interpretation No. 46, "Consolidation
          of Variable Interest Entities" ("FIN 46"). The objective of FIN 46 is
          to improve financial reporting by companies involved with variable
          interest entities. A variable interest entity is a corporation,
          partnership, trust, or any other legal structure used for business
          purposes that either (a) does not have equity investors with voting
          rights or (b) has equity investors that do not provide sufficient
          financial resources for the entity to support its activities. FIN 46
          requires a variable interest entity to be consolidated by a company if
          that company is subject to a majority of the risk of loss from the
          variable interest entity's activities or entitled to receive a
          majority of the entity's residual returns or both. FIN 46 also
          requires disclosures about variable interest entities that the company
          is not required to consolidate but in which it has a significant
          variable interest. The consolidation requirements of Interpretation 46
          apply immediately to variable interest entities created after January
          31, 2003.

          The consolidation requirements apply to holder entities in the first
          fiscal year or interim period ending after March 15, 2004. Certain of
          the disclosure requirements apply in all financial statements issued
          after January 31, 2003, regardless of when the variable interest
          entity was established. As of December 31, 2003, the Company does not
          expect that the adoption of FIN 46 will have a material impact on its
          financial statements.


                                      F-22





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 3:- MARKETABLE SECURITIES

<TABLE>
<CAPTION>
                                             December 31, 2002                            December 31, 2003
                                 ------------------------------------------   ------------------------------------------
                                                                  Estimated                                    Estimated
                                           Gross        Gross       fair                Gross        Gross        fair
                                        unrealized   unrealized     market           unrealized   unrealized     market
                                 Cost      gains       losses       value     Cost      gains        losses      value
                                 ----   ----------   ----------   ---------   ----   ----------   ----------   ---------
<S>                              <C>        <C>         <C>          <C>      <C>       <C>           <C>        <C>
          Available-for-sale:
             Equity securities   $927       $--         $(67)        $860     $927      $302          $--        $1,229
                                 ====       ===         ====         ====     ====      ====          ===        ======
</TABLE>

          During 2001, 2002 and 2003, the Company's management evaluated whether
          the certain securities' decline in value was other than temporary, and
          other than temporary declines were recognized as loss in the amount of
          $ 1,004, $ 391 and $ 0, respectively, in its statement of operations.
          The cost basis of these securities was written down to fair value as a
          new cost basis.

          During 2001, the Company recorded proceeds from the sale of
          available-for-sale securities in the amount of $ 11,004. The gross
          realized gains on sale of available-for-sale marketable securities
          totaled $ 65.

          The net adjustment to unrealized holding gains (losses) on
          available-for-sale marketable securities included as a separate
          component of shareholders' equity totaled $ (298), $ (395) and $ 260
          in 2001, 2002 and 2003, respectively.

NOTE 4:- OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES

<TABLE>
<CAPTION>
                                                                   December 31,
                                                                 ---------------
                                                                  2002     2003
                                                                 ------   ------
<S>                                                              <C>      <C>
          Loans to employees (1)                                 $  267   $  396
          Prepaid expenses                                        1,187    1,475
          Government authorities                                    268      251
          Unbilled receivables                                      155        5
          Other                                                     300       96
                                                                 ------   ------
                                                                 $2,177   $2,223
                                                                 ======   ======
</TABLE>

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

               As of December 31, 2002 and 2003, there is no balance for such
               loans in the accounts receivable.


                                      F-23





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

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

               In addition, Aladdin Knowledge Systems Inc., a wholly-owned
               subsidiary of the Company, had entered into loan agreement with
               several of its officers in an amount aggregating to $ 124 for the
               purpose of enabling them to invest in a Delaware limited
               partnership that is also a parallel investor in Tamir Fishman
               Venture II, LLC.

NOTE 5:- INVENTORIES

<TABLE>
<CAPTION>
                                                                   December 31,
                                                                 ---------------
                                                                  2002     2003
                                                                 ------   ------
<S>                                                              <C>      <C>
          Raw materials, parts and supplies                      $2,914   $2,591
          Work-in-progress                                          616      827
          Finished products                                       2,739    2,377
                                                                 ------   ------
                                                                 $6,269   $5,795
                                                                 ======   ======
</TABLE>

NOTE 6:- INVESTMENT IN AFFILIATE

<TABLE>
<S>                                                           <C>       <C>
          Investment as of purchase date                      $   542   $   542
          Convertible bond (1)                                  1,053     1,053
          Long-term loan (1) (2)                                1,331     1,431
          Accumulated losses                                   (2,635)   (2,735)
                                                              -------   -------
                                                                  291       291
          Impairment of investment in an
             affiliate (3)                                       (291)     (291)
                                                              -------   -------
          Total investment in an affiliate
             accounted for by the equity
             method                                           $    --   $    --
                                                              =======   =======
</TABLE>

          (1)  As of December 31, 2001, $ 1,053 out of the long-term loan was
               exchanged for a convertible bond as a result of an agreement
               signed between the Company and the affiliate on March 28, 2001.

               According to the agreement, the convertible bond shall be
               redeemable by March 28, 2006, or at such time as the affiliate
               completes an equity financing in the amount of $ 2,000, whichever
               is earlier. The bond is convertible to Class A Preferred shares.

          (2)  Long-term loan - the balance is linked to the U.S. dollar and
               bears no interest. As of December 31, 2003, the loan has no
               maturity date. In 2003, the Company lent to the affiliate an
               additional amount of $ 100.

          (3)  In view of circumstances such as depressed market conditions and
               difficulties in raising additional capital that indicated that
               the carrying amount of the investment may not be recoverable, the
               Company's management decided in 2002, to write-off its investment
               in the affiliate including the long term loan and the convertible
               bond in the total amount of $ 291. The impairment charge was
               included under equity losses of an affiliate.


                                      F-24





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 7:- INVESTMENT IN OTHER COMPANY

          Through December 31, 2003 the Company had invested an aggregate amount
          of $ 5,000 in Tamir Fishman Ventures II, LLC. The Company does not
          have the ability to exercise significant influence and therefore the
          investment was stated at cost. See also Note 12c.

          As a result of significant uncertainty over the future realization of
          the investment, during 2002, based on management's most recent
          analysis, impairment losses have been identified in the amount of $
          1,038. The impairment charge is included in other expenses. During
          2003, based on management's most recent analysis, no impairment losses
          have been identified.

NOTE 8:- PROPERTY AND EQUIPMENT

<TABLE>
<CAPTION>
                                                                  December 31,
                                                               -----------------
                                                                 2002      2003
                                                               -------   -------
<S>                                                            <C>       <C>
          Cost:
             Computers and peripheral equipment                $10,598   $11,949
             Office furniture and equipment                      2,469     1,972
             Motor vehicles                                        742       574
             Leasehold improvements                              1,307     1,399
                                                               -------   -------
                                                                15,116    15,894
                                                               -------   -------
          Accumulated depreciation:
             Computers and peripheral equipment                  8,834    10,874
             Office furniture and equipment                      1,715     1,362
             Motor vehicles                                        393       329
             Leasehold improvements                                696       882
                                                               -------   -------
                                                                11,638    13,447
                                                               -------   -------
          Depreciated cost                                     $ 3,478   $ 2,447
                                                               =======   =======
</TABLE>

          Depreciation expenses for the years ended December 31, 2001, 2002 and
          2003 amounted to $ 2,149, $ 2,102 and $ 1,889, respectively.

NOTE 9:- INTANGIBLE ASSETS, NET

          a.   Intangible assets:

<TABLE>
<CAPTION>
                                                                   December 31,
                                                                 ---------------
                                                                  2002     2003
                                                                 ------   ------
<S>                                                              <C>      <C>
          Cost                                                   $1,054   $1,054
          Accumulated amortization                                  302      523
                                                                 ------   ------
                                                                 $  752   $  531
                                                                 ======   ======
</TABLE>


                                      F-25





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 9:- INTANGIBLE ASSETS, NET (Cont.)

          b.   Amortization expenses for the years ended December 31, 2001, 2002
               and 2003 amounted to $ 94, $ 208 and $ 221, respectively.

          c.   Estimated amortization expenses for the years ended:

<TABLE>
<S>                                         <C>
               2004                         $208
               2005                          208
               2006                          115
                                            ----
                                            $531
                                            ====
</TABLE>

NOTE 10:- GOODWILL

          The results of operations presented below for the three years ended
          December 31, 2001, 2002 and 2003, respectively, reflect the operations
          had the Company adopted the non-amortization provisions of SFAS No.
          142 effective January 1, 2002:

<TABLE>
<CAPTION>
                                                       Year ended December 31,
                                                     ---------------------------
                                                       2001       2002     2003
                                                     --------   -------   ------
<S>                                                  <C>        <C>       <C>
          Reported net income (loss)                 $(14,915)  $(6,636)  $2,736
          Goodwill amortization                         2,172        --       --
                                                     --------   -------   ------
          Adjusted net income (loss)                 $(12,743)  $(6,636)  $2,736
                                                     ========   =======   ======
          Basic earnings (loss) per share:

          Reported net earnings (loss)               $  (1.32)  $ (0.59)  $ 0.24
          Goodwill amortization                          0.20        --       --
                                                     --------   -------   ------
          Adjusted net income (loss)                 $  (1.12)  $ (0.59)  $ 0.24
                                                     ========   =======   ======
          Diluted earnings (loss) per share:

          Reported net income (loss)                 $  (1.32)  $ (0.59)  $ 0.23
          Goodwill amortization                          0.20        --       --
                                                     --------   -------   ------
          Adjusted net income (loss)                 $  (1.12)  $ (0.59)  $ 0.23
                                                     ========   =======   ======
</TABLE>


                                      F-26





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 11:- ACCRUED EXPENSES AND OTHER ACCOUNTS PAYABLES

<TABLE>
<CAPTION>
                                                                   December 31,
                                                                 ---------------
                                                                  2002     2003
                                                                 ------   ------
<S>                                                              <C>      <C>
          Employees and payroll accruals                         $2,626   $3,160
          Accrued expenses                                          778    1,282
          Amount collected on behalf of a customer                  425      647
          Income taxes payable                                      457      306
          Other                                                     433      228
                                                                 ------   ------
                                                                 $4,719   $5,623
                                                                 ======   ======
</TABLE>

NOTE 12:- COMMITMENTS AND CONTINGENT LIABILITIES

          a.   Lease commitments:

               The Company and its subsidiaries leased their premises and motor
               vehicles under various operating lease agreements which expire in
               2008.

               Minimum lease commitments, under non-cancelable leases as of
               December 31, 2003, are as follows:

<TABLE>
<CAPTION>
                                                      Year ended December 31,
                                                  ------------------------------
                                                                 Motor
                                                  Facilities   vehicles    Total
                                                  ----------   --------   ------
<S>                                                 <C>         <C>       <C>
               2004                                 $1,574      $  977    $2,551
               2005                                  1,012         966     1,978
               2006                                    728       1,009     1,735
               2007                                    472          --       474
               2008                                    304          --       304
                                                    ------      ------    ------
                                                    $4,090      $2,952    $7,042
                                                    ======      ======    ======
</TABLE>

               Facilities lease expenses for the years 2001, 2002 and 2003
               amounted to $ 1,842, $ 1,618 and $ 1,871, respectively.

               Motor vehicle lease expenses for the years ended December 31,
               2001, 2002 and 2003 were approximately $ 581, $ 895 and $ 699,
               respectively.


                                      F-27





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 12:- COMMITMENTS AND CONTINGENT LIABILITIES (Cont.)

          b.   Litigation:

               In October 2002, a claim was brought by Hilgraeve, Inc. against
               the Company, its United States subsidiary and other companies,
               including one of its resellers, in respect of whom the Company
               agreed to represent and indemnify. The plaintiff claimed in this
               action that the eSafe product infringed on the plaintiff's United
               States patent. The plaintiff had requested an injunction and
               damages. This claim was settled at the beginning of March 2004.
               The terms of the settlement, which did not include an admission
               of liability, included payment of $550 in consideration of
               Hilgraeve's agreement to dismiss all its claims regarding the
               alleged infringement of its patent and an agreement to grant the
               Company a right to use its patent for the remaining useful life
               of the patent. The patent's original useful life was 17 years. As
               a result of the above mentioned settlement the Company recorded
               in 2003 an accrual of $200 against general and administrative
               expenses which represented past periods in which the Company
               actually used the patent.

          c.   Investment commitment:

               In February 2000, the Company signed an agreement with Tamir
               Fishman Ventures II, LLC ("TFV"). Pursuant to the agreement, the
               Company committed to invest up to $ 8,475 on demand from TFV. As
               of December 31, 2003, the Company had invested $ 5,000.

NOTE 13:- TAXES ON INCOME

          a.   Tax benefits under the Law for the Encouragement of Capital
               Investments, 1959 ("the Law"):

               Six expansion programs of Aladdin Knowledge Systems Ltd. ("AKS")
               have been granted "Approved Enterprise" status, under the Law.
               For these expansion programs, the Company has elected alternative
               benefits, waiver of grants in return for tax exemptions. Pursuant
               thereto, the income of the Company derived from the following
               "Approved Enterprise" expansion programs is tax-exempt for the
               periods stated below and will be eligible for reduced tax rates
               thereafter. Such reduced tax rates are dependent on the level of
               non-Israeli investments in the Company, as described below. The
               Company is also a "foreign investment Company", as defined by the
               Law and, as such, it is currently entitled in the third up to the
               sixth programs to a 10-year period of benefits and to a reduced
               tax rate of 20% (subject to change, based on the percentage of
               foreign ownership in each tax year).

               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 AKS to higher tax benefits than the tax benefits
               existing where AKS's offices and research and development center
               are located.

               These benefits are included in the expansion programs, as
               detailed below:

               1.   As of December 31, 2003 the benefits from the first three
                    programs have expired.


                                      F-28





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

               2.   Income derived from the fourth program, which commenced
                    December 31, 1994 and expires December 31, 2004, was tax
                    exempt for the four-year period ended December 31, 1998, and
                    is eligible for a reduced tax rate of 0%-20% for the
                    six-year period ending December 31, 2004 (depending on the
                    level of non Israeli investments in the Company).


                                      F-29





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 13:- TAXES ON INCOME (Cont.)

               3.   Income derived from the fifth program, which commenced
                    December 31, 1996 and expires December 31, 2006, entitles
                    AKS to a tax exemption for the two-year period ended
                    December 31, 1998, and to a reduced tax rate of 0%-20% for
                    the eight-year period ending December 31, 2006 (depending on
                    the level of non-Israeli investments in the Company).

               4.   Income derived from the sixth program, which commenced
                    December 31, 1998 and expires December 31, 2008, entitles
                    AKS to a tax exemption for the two-year period ended
                    December 31, 2000, and to a reduced tax rate of 0%-20% for
                    the eight-year period ending December 31, 2008 (depending on
                    the level of non-Israeli Investments in the Company).

                    The period of tax benefits, detailed above, is subject to
                    limits of the earlier of 12 years from the commencement of
                    production, or 14 years from the receiving approval.

                    The entitlement to the above benefits is conditional upon
                    the Company's fulfilling 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 canceled and the
                    Company may be required to refund the amount of the
                    benefits, in whole or in part, including interest.

                    As of December 31, 2003, management believes that the
                    Company is meeting all of the aforementioned conditions.

                    The tax-exempt income attributable to the "Approved
                    Enterprise" can be distributed to shareholders without
                    imposing tax liability on the Company only upon the complete
                    liquidation of the Company. As of December 31, 2003,
                    retained earnings included approximately $ 29,890 in
                    tax-exempt profits earned by the Company's "Approved
                    Enterprise". The Company has decided not to declare
                    dividends out of such tax-exempt income. Accordingly, no
                    deferred income taxes have been provided on income
                    attributable to the Company's "Approved Enterprise".

                    If the retained tax-exempt income is distributed in a manner
                    other than on the complete liquidation of the Company, it
                    would be taxed at the corporate tax rate applicable to such
                    profits as if the Company had not elected the alternative
                    tax benefits (currently - 20%) and an income tax liability
                    would be incurred of approximately $ 5,978 as of December
                    31, 2003.

                    Income from sources other then the "Approve Enterprise"
                    during the benefit period, will be subject to tax at the
                    regular corporate tax rate of 36%.


                                      F-30





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 13:- TAXES ON INCOME (Cont.)

                    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 abovementioned law and is taxed at
                    the regular tax rate of 36%, its effective tax rate is the
                    result of a weighted combination of the various applicable
                    rates and tax exemptions, and the computation is made for
                    income derived from each program on the basis of formulas
                    specified in the law and in the approvals.

                    By virtue of this law, the Company is entitled to claim
                    accelerated depreciation on equipment used by the "Approved
                    Enterprise" during five tax years.

               b.   Measurement of taxable income under the Income Tax
                    (Inflationary Adjustments) Law, 1985:

                    Results for tax purposes are measured and reflected in real
                    terms in accordance with the change in Israel's Consumer
                    Price Index ("CPI"). As explained in Note 2, the
                    consolidated financial statements are presented in U.S.
                    dollars. The differences between the change in Israeli's CPI
                    and in the NIS/dollar exchange rate causes a further
                    difference between taxable income and the income before
                    taxes reflected in the consolidated financial statements. In
                    accordance with paragraph 9(f) of "SFAS No. 109", the
                    Company has not provided deferred income taxes on the
                    difference between the functional currency and the tax bases
                    of assets and liabilities.

               c.   Israeli tax reform:

                    On July 24, 2002, Amendment 132 to Israel's Income Tax
                    Ordinance ("the Amendment") was approved by Israel's
                    parliament and came into effect on January 1, 2003. The
                    principal objectives of the Amendment were to broaden the
                    categories of taxable income and to reduce the tax rates
                    imposed on employees' income.

                    The material consequences of the Amendment applicable to the
                    Company include, among other things, imposing a tax upon all
                    income of Israel residents, individuals and corporations,
                    regardless the territorial source of income and certain
                    modifications in the qualified taxation tracks of employee
                    stock options.

               d.   Tax benefits under Israel's Law for the Encouragement of
                    Industry (Taxation), 1969:

                    The Company is an "industrial company", as defined by the
                    Law for the Encouragement of Industry (Taxes), 1969 and as
                    such, is entitled to certain tax benefits, mainly
                    amortization of costs relating to know-how and patents over
                    eight years and accelerated depreciation.

               e.   Income (loss) before taxes is comprised as follows:

<TABLE>
<CAPTION>
                                                       Year ended December 31,
                                                     ---------------------------
                                                       2001       2002     2003
                                                     --------   -------   ------
<S>                                                  <C>        <C>       <C>
               Domestic                              $ (2,001)  $ 1,302   $1,988
               Foreign                                (12,093)   (3,943)     897
                                                      -------    ------   ------
</TABLE>


                                      F-31





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

<TABLE>
<S>                                                  <C>        <C>       <C>
                                                     $(14,094)  $(2,641)  $2,885
                                                     ========   =======   ======
</TABLE>


                                      F-32





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 13:- TAXES ON INCOME (Cont.)

          f.   Taxes on income is comprised as follows:

<TABLE>
<CAPTION>
                                                       Year ended December 31,
                                                       -----------------------
                                                         2001    2002     2003
                                                        -----   ------   -----
<S>                                                     <C>     <C>      <C>
          Current taxes                                 $ 139   $  238   $ 399
          Deferred taxes                                 (486)   2,500    (350)
                                                        -----   ------   -----
                                                        $(347)  $2,738   $  49
                                                        =====   ======   =====
          Domestic                                      $ (69)  $  200   $ 216
          Foreign                                        (278)   2,538    (167)
                                                        -----   ------   -----
                                                        $(347)  $2,738   $  49
                                                        =====   ======   =====
</TABLE>

          g.   Deferred taxes on income:

               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:

<TABLE>
<CAPTION>
                                                                  December 31,
                                                               -----------------
                                                                 2002      2003
                                                               -------   -------
<S>                                                            <C>       <C>
          Deferred tax assets:

          Step up in FAST's assets (See also Note 15)          $ 2,454   $    --
          Reserves and allowances                                  180       344
          Net operating loss carry forwards in subsidiaries     10,706     9,503
                                                               -------   -------
          Net deferred tax assets before valuation allowance    10,886     9,847
          Valuation allowance                                   (9,702)   (8,222)
                                                               -------   -------
          Net deferred tax assets                              $ 1,184   $ 1,625
                                                               =======   =======
          Domestic                                             $   271   $   297
          Foreign                                                  913     1,328
                                                               -------   -------
                                                               $ 1,184   $ 1,625
                                                               =======   =======
</TABLE>

          The Company's subsidiaries in the U.K., Netherlands and Germany have
          estimated total available carryforward tax losses of $ 3,688, $ 443
          and $ 6,762, respectively, to offset against future tax profits for an
          indefinite period.

          The Company's subsidiaries in the U.S. and in France have estimated
          total available carryforward tax losses of $ 10,623 and $ 756, to
          offset against future tax profits for periods of 15-20 years and five
          years, respectively.


                                      F-33





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 13:- TAXES ON INCOME (Cont.)

               Management currently believes that since the Company's
               subsidiaries have a history of losses, it is more likely than not
               that the remaining deferred tax assets regarding the loss
               carryforward will not be utilized.

               Utilization of U.S. net operating losses may be subject to
               substantial annual limitations due to the "change in ownership"
               provisions of the Internal Revenue Code of 1986 and similar state
               provisions. The annual limitation may result in the expiration of
               net operating losses before utilization.

          h.   A reconciliation between the theoretical tax expense (benefit),
               assuming all income is taxed at the statutory tax rate applicable
               to income of the Company and the actual tax expense (benefit) as
               reported in the statement of operations, is as follows:

<TABLE>
<CAPTION>
                                                                  Year ended December 31,
                                                                ---------------------------
                                                                  2001       2002     2003
                                                                --------   -------   ------
<S>                                                             <C>        <C>       <C>
          Income (loss) before taxes, as reported in the
             consolidated statements of operations              $(14,094)  $(2,641)  $2,885
                                                                ========   =======   ======
          Statutory tax rate                                          36%       36%      36%
                                                                ========   =======   ======
          Theoretical tax expenses (benefit) on the above
             amount at the Israeli statutory tax rate           $ (5,074)  $  (951)  $1,039
          Decrease in taxes resulting from "Approved
             Enterprise" benefits (1)                               (532)     (176)    (153)
          Tax adjustments in respect of inflation in Israel          346      (196)      --
          Tax adjustment in respect of foreign subsidiary
             different tax rate                                       52        38       43
          Deferred taxes on losses for which valuation
             allowance was provided                                4,630     4,136      105
          Utilization of losses for which valuation allowance
             was provided in prior year                               --        --     (750)
          Non-deductible expenses                                     72      (113)    (235)
          Other                                                      159        --       --
                                                                --------   -------   ------
          Actual tax expense (benefit)                          $   (347)  $ 2,738   $   49
                                                                ========   =======   ======
          (1) Per share amounts (basic) of the tax benefit
                 resulting from the exemption                   $  (0.05)  $ (0.02)  $(0.01)
                                                                ========   =======   ======
              Per share amounts (diluted) of the tax
                 benefit resulting from the exemption           $  (0.05)  $ (0.02)  $(0.01)
                                                                ========   =======   ======
</TABLE>


                                      F-34





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 14:- SHAREHOLDERS' EQUITY

          a.   The Ordinary shares of the Company quoted on the NASDAQ National
               Market.

          b.   The Ordinary shares confer upon their holders the right to
               receive notice to participate and vote in general meetings of the
               Company, and the right to receive dividends, if declared.

          c.   In October 2000, 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, out of which, during 2003, 151,480
               shares were reissued from the share repurchase program for a
               total consideration of $ 456.

               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
               reissuance in accordance with Accounting Principles Board Opinion
               No. 6 "Status of Accounting Research Bulletins" ("APB No. 6") and
               charges the excess of the repurchase cost over issuance price
               using the weighted average method to retained earnings. In case
               the repurchase cost is lower than the issuance price, the Company
               credits the excess cost to additional paid-in capital.

          d.   Employee Share Option Plans:

               Between 1993 and 2003, the Company implemented several Employee
               Share Options Plans ("the plans"). Total number of options
               authorized for grant under the plans amounted to 2,773,750. As of
               December 31, 2003, an aggregate of 43,100 options of the Company
               were still available for future grants.

               Under the Company's plans, full-time employees, officers and
               directors of the Company may be granted options to acquire
               Ordinary shares. The options granted are at an exercise price
               that equals the fair market value of the shares at the date of
               grant. The options generally vest over a period of two to four
               years from the date of grant, and expire no later than five to 10
               years from the date of grant. Any options that are canceled or
               forfeited before expiration become available for future grants.


                                      F-35





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 14:- SHAREHOLDERS' EQUITY (Cont.)

               A summary of the Company's share option activity under the plans
               is as follows:

<TABLE>
<CAPTION>
                                                  2001                     2002                    2003
                                         ---------------------   ----------------------   ---------------------
                                                      Weighted                 Weighted                Weighted
                                                      average                  average                 average
                                           Amount     exercise     Amount      exercise     Amount     exercise
                                         of options    price     of options      price    of options     price
                                         ----------   --------   -----------   --------   ----------   --------
<S>                                      <C>            <C>       <C>            <C>      <C>            <C>
               Outstanding - beginning
                  of the year            1,224,116      $5.98     1,633,500      $4.48    1,683,400      $3.62
                  Granted                  717,050      $2.77       397,100      $1.20      638,150      $4.80
                  Exercised                     --      $  --            --      $  --     (151,480)     $3.01
                  Forfeited               (307,666)     $6.46      (347,200)     $4.88     (231,875)     $5.51
                                         ---------                ---------               ---------
               Outstanding - end of
                  the year               1,633,500      $4.48     1,683,400      $3.62    1,938,195      $3.73
                                         =========                =========               =========
               Options exercisable at
                  the end of the year      422,500      $7.32       660,392      $5.29    1,023,583      $4.15
                                         =========      =====     =========      =====    =========      =====
</TABLE>

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

<TABLE>
<CAPTION>
                                                          Weighted average fair value of
                                                       options granted at an exercise price
                                                       ------------------------------------
                                                                2001    2002    2003
                                                               -----   -----   -----
<S>                                                            <C>     <C>     <C>
               Equals fair value at date of grant              $0.68   $0.26   $2.46
                                                               =====   =====   =====
               Less than fair value at date of grant           $  --   $  --   $1.82
                                                               =====   =====   =====
</TABLE>

               The options outstanding as of December 31, 2003, have been
               separated into exercise price categories, as follows:

<TABLE>
<CAPTION>
                                                                                      Weighted
                               Options       Weighted                   Options       average
                            outstanding       average     Weighted    exercisable    exercise
                Range of        as of        remaining     average       as of       price of
                exercise    December 31,    contractual   exercise   December 31,     options
                  price         2003       life (years)     price        2003       exercisable
               ----------   ------------   ------------   --------   ------------   -----------
<S>                           <C>                <C>        <C>        <C>             <C>
               $1.20-2.67       955,908          9          $2.00        431,405       $2.18
               $3.50-4.80       633,937          4          $4.42        388,728       $4.36
               $7.50-8.52       348,350          7          $8.16        203,450       $7.92
                              ---------                                ---------
                              1,938,195                     $3.73      1,023,583       $4.15
                              =========                     =====      =========       =====
</TABLE>

          e.   Dividends:

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


                                      F-36





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 15:- RELATED PARTY TRANSACTIONS

          Long-term note receivable - related parties:

          FAST Multimedia AG ("FAST") is a wholly-owned subsidiary of FAST
          Multimedia, Inc., an entity controlled by the previous principal
          shareholder of FAST and a director of the Company. Amounts receivable
          from FAST were unsecured, fully subordinated to all other liabilities
          of FAST, bore interest at FIBOR plus 3% (FIBOR + 1.5% at December 31,
          1997) and became due on June 30, 2001.

          In January 2001, the Company signed an agreement to convert the
          long-term note receivable in the amount of $ 3,350 from FAST into
          1,741,644 Series C Preferred shares of FAST Multimedia Inc. These
          shares represented 11.93% of the outstanding share capital of FAST
          Multimedia Inc.

          In September 2001, FAST sold its business activities to Pinnacle
          System, which is listed for trading on the stock exchange in the U.S.
          in exchange for cash and shares of Pinnacle System.

          In view of the value of the transaction, and in view of the estimation
          of the Company's management that it will not be possible to realize
          the investment, management decided to write-off the balance of its
          investment in FAST and to recognize a loss in respect to this
          investment.

          The loss in respect of this investment, in the amount of $ 3,350 was
          recorded in 2001 under the other expenses item in the statements of
          operations.

          In May 2002, the Company received $ 261 as a result of FAST's business
          acquisition by Pinnacle System. This amount was recorded in other
          income.

NOTE 16:- GEOGRAPHIC INFORMATION

          Summary information about geographic areas:

          The Company adopted Statement of Financial Accounting Standard No.
          131, "Disclosures About Segments of an Enterprise and Related
          Information",("SFAS No. 131"). The Company operates in one reportable
          segment (see Note 1 for a brief description of the Company's
          business). The total revenues are attributed to geographic areas based
          on the location of the end customer.


                                      F-37





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 16:- GEOGRAPHIC INFORMATION (Cont.)

          The following present total revenues for the years ended December 31,
          2001, 2002 and 2003 and long-lived assets as of December 31, 2001,
          2002 and 2003:

<TABLE>
<CAPTION>
                                                             Year ended December 31,
                                                           ---------------------------
                                                             2001      2002      2003
                                                           -------   -------   -------
<S>                                                        <C>       <C>       <C>
          Revenues from sales to unaffiliated customers:
             Israel                                        $ 2,428   $ 1,949   $ 2,025
             Germany                                         9,725     9,214    12,124
             United States                                  15,091    17,484    17,621
             Europe (excluding Germany)                     12,531    13,273    13,826
             South East Asia                                 5,753     6,241     7,866
             Others                                          1,085     1,359     1,263
                                                           -------   -------   -------
                                                           $46,613   $49,520   $54,725
                                                           =======   =======   =======
          Long-lived assets:
             Israel                                        $ 7,893   $ 6,762   $ 6,009
             Germany                                           366       323       325
             United States                                   3,459     3,398     2,983
             Europe (excluding Germany)                        890       827       719
             South East Asia                                   187       201       223
                                                           -------   -------   -------
                                                           $12,795   $11,511   $10,259
                                                           =======   =======   =======
</TABLE>

          Total revenues from outside customers are distributed among the
          following product lines:

<TABLE>
<CAPTION>
                                                       Year ended December 31,
                                                     --------------------------
                                                       2001      2002     2003
                                                     -------   -------   ------
<S>                                                  <C>       <C>       <C>
          Tokens (including HASP,
             Hardlock and Microguard)                $37,207   $37,388   $41,217
          eSafe                                        7,341     7,274     7,662
          eToken                                         851     2,153     3,542
          Others                                       1,214     2,705     2,304
                                                     -------   -------   -------

                                                     $46,613   $49,520   $54,725
                                                     =======   =======   =======
</TABLE>


                                      F-38





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 17:- SELECTED STATEMENTS OF OPERATIONS DATA

<TABLE>
<CAPTION>
          a.   Financial income (expenses):

                                                              Year ended December 31,
                                                             -------------------------
                                                               2001      2002     2003
                                                             -------   -------   -----
<S>                                                          <C>       <C>       <C>
          Financial expenses:

             Impairment of available-for-sale marketable
                securities                                   $(1,004)  $  (391)  $  --
             Foreign currency translation differences           (212)       --      --
             Other                                              (140)     (143)   (219)
                                                             -------   -------   -----
                                                              (1,356)     (534)   (219)
                                                             -------   -------   -----
          Financial income:

             Income from interest on marketable securities       384        --      --
             Interest                                            562       171     161
             Foreign currency translation differences             --       827     538
             Other                                                --        27      --
                                                             -------   -------   -----
                                                                 946     1,025     699
                                                             -------   -------   -----
                                                             $  (410)  $   491   $ 480
                                                             =======   =======   =====
</TABLE>

          b.   Other expenses, net:

<TABLE>
<S>                                                          <C>       <C>       <C>
          Impairment of investment in other company          $    --   $(1,038)  $  --
          Impairment of investment in FAST                    (3,350)       --      --
          Other, net                                             (22)      106      (5)
                                                             -------   -------   -----
                                                             $(3,372)  $  (932)  $  (5)
                                                             =======   =======   =====
</TABLE>


                                      F-39





<PAGE>


                                                  ALADDIN KNOWLEDGE SYSTEMS LTD.
                                                            AND ITS SUBSIDIARIES

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

NOTE 17:- SELECTED STATEMENTS OF OPERATIONS DATA (Cont.)

          c.   Net earnings (loss) per share:

               The following table sets forth the computation of basic and
               diluted net earnings (loss) per share:

<TABLE>
<CAPTION>
                                                                      Year ended December 31,
                                                                  -----------------------------
                                                                    2001       2002       2003
                                                                  --------   --------   -------
<S>                                                               <C>        <C>        <C>
               1. Numerator:

                   Net income (loss) to shareholders of
                      Ordinary shares                             $(14,915)  $ (6,636)  $ 2,736
                                                                  ========   ========   =======

                   Numerator for basic and diluted net
                      earnings (loss) per share - income (loss)
                      available to Ordinary shareholders          $(14,915)  $ (6,636)  $ 2,736
                                                                  ========   ========   =======
               2. Denominator:

                   Weighted average number of shares                11,466     11,477    11,477
                   Weighted average number of treasury shares         (191)      (224)     (190)
                                                                  --------   --------   -------

                   Denominator for basic net earnings (loss)
                      per share                                     11,275     11,253    11,287
                                                                  --------   --------   -------
                   Effect of dilutive securities:
                   Employee stock options                             *)--       *)--       663
                                                                  --------   --------  -------
                   Dilutive potential Ordinary shares                 *)--       *)--       663
                                                                  --------   --------   -------

                   Denominator for diluted net earnings (loss)
                      per share - adjusted weighted average
                      shares, assumed exercise of options           11,275     11,253    11,950
                                                                  ========   ========   =======
</TABLE>

               *) Antidilutive.

                                   ----------


                                      F-40





<PAGE>


                                   SIGNATURE

The registrant hereby certifies that it meets all of the requirements for filing
on Form 20-F and that it has duly caused and authorized the undersigned to sign
this annual report, as amended, on its behalf.

                                        Aladdin Knowledge Sytems Ltd.


                                        By: /s/ Jacob (Yanki) Margalit
                                            ------------------------------------
                                        Name: Jacob (Yanki) Margalit
                                        Title: Chairman of the Board and
                                               Chief Executive Officer

Date: March 15, 2005


                                       76



                         STATEMENT OF DIFFERENCES
                         ------------------------
The trademark symbol shall be expressed as.............................. 'TM'
The registered trademark symbol shall be expressed as................... 'r'