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SECURITIES AND EXCHANGE COMMISSIONWASHINGTON,
D.C. 20549

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FORM 20-F

|For the fiscal year ended December 31, 2003.         Commission File No. 1-8201
|-------------------------------------------------------------------------------

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

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Israel(Jurisdiction of incorporation or organization)

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

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

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

11,477,922 Ordinary Shares

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

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

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

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PART I

Item
1.          Identity of
Directors, Senior Management and Advisers

Not Applicable

Item
2.          Offer
Statistics and Expected Timetable

Not Applicable

Item 3.          Key
Information

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.

2

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|                           |                                                                                          | December
  31,                                       |  
|-------------------------- | ---------------------------------------------------------------------------------------- | ---------------------------------------------------- | -
|                           |                                                                                          |                                                      |  
|                           |                                                                                          | 2003                                                 |  
|                           |                                                                                          |                                                      |  
|                           |                                                                                          |                                                      |  
|                           |                                                                                          | (U.S.
  dollars in thousands, except per share data) |  
|                           |                                                                                          |                                                      |  
|Statement
  of Income Data |                                                                                          |                                                      |  
|Revenues:                  |                                                                                          |                                                      |  
|                           | Software security                                                                        |                                                      | $
|                           | Enterprise security                                                                      |                                                      |  
|                           |                                                                                          |                                                      |  
|                           |                                                                                          |                                                      |  
|                           | Total                                                                                    |                                                      |  
|                           |                                                                                          |                                                      |  
|                           | Cost of revenues:                                                                        |                                                      |  
|                           | Software security                                                                        |                                                      |  
|                           | Enterprise security                                                                      |                                                      |  
|                           |                                                                                          |                                                      |  
|                           | Total                                                                                    |                                                      |  
|                           |                                                                                          |                                                      |  
|                           | Gross profit                                                                             |                                                      |  
|                           | Operating expenses:                                                                      |                                                      |  
|                           | Research and
  development                                                               |                                                      |  
|                           | Selling and marketing                                                                    |                                                      |  
|                           | General and
  administrative                                                             |                                                      |  
|                           | Impairment of
  intangibles assets                                                       |                                                      |  
|                           |                                                                                          |                                                      |  
|                           | Total operating expenses                                                                 |                                                      |  
|                           |                                                                                          |                                                      |  
|                           | Operating income (loss)                                                                  |                                                      |  
|                           | Financial income
  (expenses), net                                                       |                                                      |  
|                           | Other income
  (expenses),net                                                            |                                                      |  
|                           |                                                                                          |                                                      |  
|                           | Income (loss) before
  taxes                                                             |                                                      |  
|                           | Taxes on income                                                                          |                                                      |  
|                           |                                                                                          |                                                      |  
|                           | Income (loss) before
  equity in losses of an
  affiliate                                |                                                      |  
|                           | Equity in losses of an
  affiliate                                                       |                                                      |  
|                           |                                                                                          |                                                      |  
|                           | Net income (loss)                                                                        |                                                      | $
|                           |                                                                                          |                                                      |  
|                           | Net earnings (loss) per
  share:                                                         |                                                      |  
|                           | Basic                                                                                    |                                                      | $
|                           | Diluted                                                                                  |                                                      | $
|                           | Weighted average number
  of shares used in
  computing net earnings
  (loss) per share: |                                                      |  
|                           | Basic                                                                                    |                                                      |  
|                           | Diluted                                                                                  |                                                      |  

3

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| |                                                                                     |  | December
  31,              |       
| | ----------------------------------------------------------------------------------- |  | --------------------------- | ------
| |                                                                                     |  | 2003                        |       
| |                                                                                     |  |                             |       
| |                                                                                     |  | U.S.
  dollars in thousands |       
| | Balance
  Sheet Data:                                                               |  |                             |       
| | Cash and cash
  equivalents, short term
  bank deposits and
  marketable securities |  | $                           | 19,516
| | Working capital                                                                     |  | $                           | 26,625
| | Total assets                                                                        |  | $                           | 55,468
| | Total liabilities                                                                   |  | $                           | 14,512
| | Shareholders equity                                                                |  | $                           | 40,956

B.
CAPITALIZATION AND INDEBTEDNESSNot applicable.

C. REASONS FOR THE OFFER AND USE OF PROCEEDSNot 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.

4

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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 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 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.

5

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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:

| | unexpected changes in
  regulatory requirements, tariffs and other trade barriers;
|- | ----------------------------------------------------------------------------------
|  |                                                                                   
| | difficulties in staffing
  and managing foreign operations;                       
|  |                                                                                   
| | political instability;                                                            

6

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| | fluctuations in currency
  exchange rates or restrictions on conversion of foreign currencies;
|- | ----------------------------------------------------------------------------------------------
|  |                                                                                               
| | reduced protection for
  intellectual property rights in some countries;                      
|  |                                                                                               
| | burdens with complying
  with a wide variety of foreign laws and regulations;                 
|  |                                                                                               
| | potentially adverse tax
  consequences; and                                                   

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.

7

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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 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:

| | some foreign countries may
  not protect our proprietary rights as fully as do the laws of the United
  States;                                                                      
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                      
| | if a competitor were to
  infringe on our proprietary rights, enforcing our rights may be time
  consuming and costly, diverting both our managements attention and our
  resources;
|  |                                                                                                                                                                                      
| | measures like entering
  into non-disclosure agreements afford only limited protection;                                                                                              
|  |                                                                                                                                                                                      
| | unauthorized parties may
  attempt to copy aspects of our products and develop similar software or to
  obtain and use information that we regard as proprietary; and                
|  |                                                                                                                                                                                      
| | our competitors may be
  able to independently develop products that are substantially equivalent or
  superior to our products or design around our intellectual property rights.   

We may not be able to 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.

8

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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 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.

9

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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:

| | diversion of our
  management time after consummation of the acquisition from the ongoing
  development of our businesses, and the release of future products and
  services;                                                                           
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                         
| | decline in employee morale
  and retention issues, both at our company and at the acquired company,
  resulting from changes in compensation, reporting relationships, future
  prospects or the direction of the business; and                         
|  |                                                                                                                                                                                                                                                         
| | the need to integrate new
  product lines and accounting, management information, human resource and
  other administrative systems to permit effective management, and the risk of
  disorganization if this integration is delayed or not implemented.

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

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

As
a result of our research and development activities in Israel, we are required
to obtain export permission from the Israeli government before exporting
certain technologies.We have
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.

10

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Risks Related to our Ordinary
Shares

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

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

| |  | quarter-to-quarter
  fluctuations in our financial results;                      
| | - | ---------------------------------------------------------------------------------
| |   |                                                                                  
| |  | under or over performance
  against analysts estimates;                         
| |   |                                                                                  
| |  | changing laws and
  government regulations relating to our business;             
| |   |                                                                                  
| |  | increased market share
  penetration by our competitors;                         
| |   |                                                                                  
| |  | general economic
  conditions;                                                   
| |   |                                                                                  
| |  | increased operating costs,
  particularly with regard to machinery and personnel;
| |   |                                                                                  
| |  | additions or departures of
  key personnel;                                      
| |   |                                                                                  
| |  | sales of additional
  ordinary shares;                                           
| |   |                                                                                  
| |  | political, economic or
  other developments affecting Israel; and                
| |   |                                                                                  
| |  | stock market volatility.                                                         

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

Due
to the 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.

11

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

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

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

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

If
our ordinary shares were delisted from the NASDAQ National Market, we would
seek to have the ordinary shares traded in the NASDAQ SmallCap Market or
another national securities exchange. However, 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 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.

12

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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 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.

13

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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® (Hardware Against
Software Piracy), HASP DocSeal, Hardlock® and Privilege. 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® and eToken. 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 eToken R2, eToken Pro, and eToken Enterprise. A
Software Developers Kit is available for creating custom eToken applications.

14

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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:

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

According to the 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.

15

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Due to the risk of
substantial loss of revenue as a result of software piracy, software developers
have a need to protect their software against unauthorized use. However,
developers of low cost, shrink wrap software generally do not find the use of
sophisticated mechanisms to protect their software cost-effective. Most users
of sophisticated protection products today are software developers that sell
products at relatively higher price levels, typically in excess of $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:

| | 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.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

We currently offer 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.:

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|HASP
  Product | Functionality                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | Port         
|-------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------
|               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |              
|HASP4 Std      |     Copy protection
      1 perpetual license
      Cross platform 
        supports numerous
        operating systems
        (Windows, Macintosh,
        Linux)                                                                                                                                                                                                                                                                                                                                         | USB, Parallel
|HASP4 M1       |     Copy protection,
      Licensing  can store
        up to 16 licenses on
        one token
      112 bytes memory
      Supports components
        licensing  enables
        licensing of several
        components, modules
        or applications on one
        token
      Demo licensing 
        enables creation of
        demo versions of
        applications protected
        with the token
      Pay-per-use
      Cross platform
         (Windows, Macintosh,
        Linux) | USB, Parallel

18

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|HASP4 M4   |     Copy protection
      Licensing  can store
        up to 112 licenses on
        one token
       496 bytes memory
       Supports components
        licensing
       Demo licensing
       Pay-per-use
       Cross platform
        (Windows, Macintosh,
        Linux)                                                                                                                                                                                   | USB, Parallel, PCMCIA
|---------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ---------------------
|HASP4 Time |     Copy protection
      Licensing  can store
        up to 8 licenses
      512 bytes memory
      Supports rental and
        subscription licensing
      Cross platform
        (Windows, Macintosh,
        Linux)                                                                                                                                                                                                                                           | USB, Parallel        
|HASP4 Net  |     Copy protection
      Licensing  can store
        up to 112 licenses
      496 bytes memory
      Supports floating
        licenses  enables
        concurrent users of
        license in network
        environment and
        manages how many
        users can
        simultaneously run
        application
      Components licensing
      Demo licensing
      Pay-per-use
      Cross platform
        (Windows, Macintosh,
        Linux) | USB, Parallel        

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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:

|Hardlock
  Product | Functionality                                                                                                                                | Port                                     
|------------------ | -------------------------------------------------------------------------------------------------------------------------------------------- | -----------------------------------------
|                   |                                                                                                                                              |                                          
|Hardlock Eye Std   |     Copy protection                                                                                                                         | Parallel                                 
|Hardlock Eye Mem   |     Copy protection
      Licensing
      128 byte memory                                                                                 | Parallel                                 
|Hardlock Twin      |     Copy protection
      Licensing
      Combined parallel and
        serial connector in a
        single token
      128 byte memory | Parallel and Serial                      
|Hardlock USB       |     Copy protection
      Licensing
      128 byte memory                                                                                 | USB                                      
|Hardlock PCMCIA    |     Copy protection
      Licensing.                                                                                                       | PCMCIA                                   
|Hardlock Server    |     Copy protection
      Floating licensing
      128 byte memory                                                                        | Parallel, USB                            
|Hardlock Internal  |     Copy protection
      Licensing
      128 byte memory                                                                                 | A card that connects internally to the PC

Microguard
Product Line

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

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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 Privilegeallows
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.

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

|                                                                                                                                         | sell and distribute software products via the
  Internet through multiple channel partners, each with individual terms,
  without having to maintain multiple electronic distribution platforms;
|----------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                         | manage the full product lifecycle, from product
  development through end-customer usage rights; and                                                                                            
|                                                                                                                                         | trial-enable software, including electronically
  enabled try-before-you-buy models.                                                                                                            
|We recently released Privilege 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 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.

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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:

| | The Integrated gateway and
  mail solution - eSafe Gateway
|- | ----------------------------------------------------------
| | The Internet gateway
  solution  eSafe Web               
|  |                                                           
| | 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:

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

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eSafe Web

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

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

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

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

SmartScript
Filtering

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

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

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

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NitroInspection

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

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

Anti-Spam

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.

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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 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:

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

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.

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In 2001, we entered into
distribution agreements with leading distributors in Europe (Articon-Integralis)
and the United States (Westcon Group). 
We have continued our relationship with these distributors in 2002 and
into 2003. The Alasso unit of Articon-Integralis was recently sold by Articon-Integralis to InTechnology plc and we
have maintained our relationship with Alasso. 
We have also entered into an agreement with Digital River, Inc., which
allows us to offer our products and services to their customers at our standard
rates. We intend to continue to target resellers and system integrators that focus
on providing security solutions to enterprises. In addition, we 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. 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.

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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:

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|Year
  ending
  December
  31, |                                | Percentage
  of sales in, |       
|------------------------------ | ------------------------------ | ------------------------- | ------
|                               |                                |                          
|                               | Europe
  (excluding
  Germany) |                           | Israel
|                               |                                |                           |       
|                               |                                |                           |       
|2003                           |                                | 25.3%                     |       
|                               |                                |                           |       
|2002                           |                                | 26.8%                     |       
|                               |                                |                           |       
|2001                           |                                | 26.9%                     |       

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.

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In addition we have a
wholly owned holding company, Hafalad BV, which is incorporated in Holland.
Through Hafalad we wholly own Aladdin Western Europe BV (formerly known as
Aladdin Knowledge Systems BV), Aladdin Western Europe (Aladdin France S.A.R.L.)
(formerly known as Aladdin France S.A) 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.

Item
5.          Operating and
Financial Review and Prospects

Critical Accounting
Policies

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

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We believe that the
application of the following critical accounting policies entails the most
significant judgments and estimates used in the preparation of our consolidated
financial statements

Revenue recognition. Our products are
generally a bundled hardware and software solution that are delivered together.
Revenues from products are recognized in accordance with Staff Accounting
Bulletin No. 104
when the following criteria are met: persuasive evidence of an arrangement
exists, delivery of the product has occurred, the fee is fixed or determinable,
collectibility is probable and we do not have any obligation to customers after
the date in which products are delivered.

We generate revenues from
licensing the right to use our software products, from the sale of products,
maintenance and updates directly to end-users and indirectly mostly through
value-added resellers, original equipment manufacturers and independent
distributors (all of them are considered end users).

Revenues from software
license agreements are recognized, in accordance with Statement of Position
97-2, Software Revenue Recognition, as amended (SOP 97-2). SOP 97-2
generally requires revenue earned on software arrangements involving multiple
elements to be allocated to each element based on the relative fair value of
the elements. In addition the Company has adopted Statement of Position 98-9,
Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain
Transactions, (SOP 98-9). SOP 98-9 requires that revenue be recognized under
the residual method when Vendor Specific Objective Evidence (VSOE) of Fair
Value exists for all undelivered elements and VSOE does not exist for all of
the delivered elements. Under the residual method any discount in the
arrangement is allocated to the delivered elements.

Revenue
from license fees is 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.

Maintenance
and support revenue included in multiple element arrangements 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, support and services) 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, we recognize the
license and maintenance revenue ratably over the period of each arrangement.

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

Accounts Receivable.We are required
to perform ongoing credit evaluations of our trade receivables. We maintain an
allowance for doubtful accounts. Management exercises its judgment as to our
ability to collect outstanding receivables. Provisions are made based upon a
specific review of all the outstanding invoices.In determining the provisions, we analyze
our historical collection experience and current economic trends. If the financial condition of our
customers in general deteriorates, our revenues growth might be limited and additional
allowances might be required.

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Inventories. Inventories are stated at
the lower of cost or market value. Cost is determined by the average cost
method. We periodically evaluate our quantities on hand relative to current and
historical selling prices and historical and projected sales volume. Based on
these evaluations, inventory write-offs and write-down provisions are provided
to cover risks arising from slow moving items. 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.

Deferred tax. We record a valuation
allowance to reduce our deferred tax assets to the amount that we believe is
likely to be realized. In assessing the need for a valuation allowance, we
consider all positive and negative evidence, including reversals of existing
deferred tax liabilities, estimated future taxable income, prudent and feasible
tax planning strategies, and recent financial performance. Due to the history
of losses in most of our subsidiaries and the estimation that it is more likely
than not that the net deferred tax assets related to our subsidiaries loss
carry-forwards and other reserves and allowances will not be utilized, we
concluded that a valuation allowance of $8.2 million against our net
deferred tax assets related to our subsidiaries loss carry-forwards and other
reserves and allowances, at December 31, 2003 was appropriate. If, in the
future, we believe that a deferred tax asset will be realized, for which we
currently have a valuation allowance, we will be required to reverse the valuation
allowance, which could result in an income tax benefit in the period of such
determination.

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

A. OPERATING RESULTS

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

|                                                        |  | 2003  |   | 2002   |   | 2001   |  
|------------------------------------------------------- |  | ----- | - | ------ | - | ------ | -
|                                                        |  |       |   |        |   |        |  
|                                                        |  | %     |   | %      |   | %      |  
|Revenues                                                |  |       |   |        |   |        |  
|Software security                                       |  | 79.51 |   | 80.96  |   | 82.43  |  
|Enterprise security                                     |  | 20.49 |   | 19.04  |   | 17.57  |  
|Total                                                   |  | 100   |   | 100    |   | 100    |  
|Cost of revenues                                        |  |       |   |        |   |        |  
|Software security                                       |  | 14.61 |   | 16.26  |   | 16.63  |  
|Enterprise security                                     |  | 3.30  |   | 4.41   |   | 3.37   |  
|Total                                                   |  | 17.91 |   | 20.67  |   | 20.00  |  
|Gross profit                                            |  | 82.09 |   | 79.33  |   | 80.00  |  
|Research and development                                |  | 23.32 |   | 24.73  |   | 23.70  |  
|Selling and marketing                                   |  | 40.22 |   | 44.41  |   | 48.21  |  
|General  & administrative                               |  | 14.15 |   | 14.63  |   | 19.04  |  
|Impairment of intangibles assets                        |  | --    |   | --     |   | 11.18  |  
|Operating income (loss)                                 |  | 4.40  |   | (4.44  | ) | (22.12 | )
|                                                        |  |       |   |        |   |        |  
|Financial income (expenses), net                        |  | 0.88  |   | 1.00   |   | (0.88  | )
|Other income (expenses), net                            |  | (0.01 | ) | (1.88  | ) | (7.23  | )
|Income (loss) before taxes                              |  | 5.27  |   | (5.33  | ) | (30.24 | )
|Taxes on income                                         |  | 0.09  |   | 5.53   |   | (0.74  | )
|Income (loss) before equity in
  losses of an affiliate |  | 5.18  |   | (10.86 | ) | (29.49 | )
|Equity in losses of an affiliate                        |  | (0.18 | ) | (2.54  | ) | (2.51  | )
|                                                        |  |       |   |        |   |        |  
|Net income (loss)                                       |  | 5.00  |   | (13.40 | ) | (32.00 | )

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Year Ended December 31, 2003 Compared to Year Ended December
31, 2002

Revenues.Revenues increased
approximately 10.5% to $54.72 million during 2003 compared with revenues of
$49.52 million during 2002. This increase was primarily a result of worldwide
growth across all our product lines. 2003 Software Security (Digital Rights
Management) sales were $43.52 million, an increase of 8.6% over 2002.
Enterprise Security Sales reached $11.20 million, an increase of 18.9% over
2002.

Cost of revenues.Cost of revenues
primarily includes the manufacturing cost of the hardware and overhead related
to manufacturing activity. Cost of revenues was approximately $9.80 million
during 2003 compared with $10.24 million in 2002, a decrease of 4.3%. The main
reasons for this were the increase of our software based products, in dollars and
as percentage of revenues and the efficiencies in manufacturing
processes caused by lower overhead costs. The software based products offer a lower percentage
of costs in terms of dollars than the hardware based products. Since the cost
of revenues is different for all of the products we produce, a change in the
mix of products we produce in any given year will subsequently change our cost
of revenues in that year. Cost of revenues, as a percentage of total revenues,
decreased to 17.9% in 2003 from to 20.7% in 2002.

Research and development expenses.Research
and development expenses consist primarily of compensation and related costs of
employees engaged in on-going research and development activities, costs of
subcontractors and related expenses. Research and development expenditures
increased 4.2% to approximately $12.76 million during 2003, as compared to
$12.24 million during 2002. As a percentage of revenues, research and
development expenses, decreased to 23.3% in 2003 from 24.7% during 2002. This
increase in terms of dollars is 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.

Selling and Marketing expenses.
Selling and marketing expenses consist primarily of compensation for sales and
marketing personal, exhibitions, travel and related expenses. Selling and
marketing expenses were stable in 2003 as compared to expenses in 2002 and
totaled approximately $22 million. As a percentage of revenues, selling and
marketing expenses, decreased to 40.2% in 2003 from 44.4% during 2002. This
level of stability of the selling and marketing expenses was a result of the
continuation of the implementation of our marketing plan with respect to the
various products of the Company.

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General and administrative expenses.General
and administrative expenses consist primarily of compensation for finance and
human resources, allowance for bad debt, goodwill amortization as well as
professional and legal service expenses. General and administrative expenses
increased to approximately $7.7 million during 2003 as compared to $7.2 million
during 2002. As a percentage of revenues, general and administrative expenses,
decreased to 14.1% in 2003 from 14.6% during 2002. The most significant reason
for this increase was, our professional and legal related costs that were
increased due to legal procedures that the Company has been involved in, as a
plaintiff or as a defendant. (See item 8: Financial Information--Legal
Proceedings)

Restructuring charges.As a result of
the downturn in the global economic conditions, the decline in overall business
levels and the related impact on our operations, we implemented during 2002 a
worldwide restructuring and cost reduction plan, including at the level of our
subsidiaries. In 2002 we, together with our subsidiaries, recorded expenses of
approximately $1.12 million, out of which $467,000 were included in research
and development expenses, $500,000 in selling and
marketing expenses and $156,000 in general and administrative expenses.
These costs were associated primarily with a reduction in work
force and general reduction in all operating expenses. There were no
restructuring charges in 2003.

Financial income, net. Financial
income consists primarily of interest derived from cash and cash equivalents,
net of bank charges, gain (loss) from exchange rates difference and impairment
of the Companys investment in equity securities. Financial
income in 2003 was $480,000 compared with financial income of $491,000 in 2002.
The interest derived from cash and cash equivalents remained relatively
constant throughout the periods presented. The Euro, the British Pound and the
Japanese Yen currencies continued to strengthen against the dollar and
continued generating gains from exchange rates in 2003.

Other expenses, net.Other expenses,
net, were approximately $5,000 in 2003 compared with $932,000 in 2002. Other
expenses in 2003 were primarily generated by national insurance costs from
prior years, which partially offset by gain from selling of motor vehicles.
Other expenses in 2002 were primarily generated by the write off of our
investment in Tamir Fishman Ventures II.

Taxes on income.Taxes on income were
approximately $49,000 in 2003 compared to approximately $2.7 million in 2002.
Taxes on income in 2003 were primarily due to an income tax provision from ongoing
operations of approximately $399,000 and deferred tax income of approximately
$350,000 regarding carry-forward losses. Taxes on income in 2002 were primarily
due to an income tax provision from ongoing operations of approximately
$200,000 and due to the increase of the valuation allowance for deferred tax
assets of approximately $2.5 million. The increase of the valuation allowance
is due to the fact that the Companys ability to use the remaining net
operating loss carry forward is dependent upon future taxable income.

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

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

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

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Research and development expenses.
Research and development expenses consist primarily of compensation and related
costs of employees engaged in on-going research and development activities,
costs of subcontractors and related expenses. Research and development
expenditures increased 10.9% to approximately $12.24 million during 2002, as
compared to $11.04 million during 2001. As a percentage of revenues, research
and development expenses, increased to 24.7% in 2002 from 23.7% during 2001.
This increase was due to an increase in compensation expenses resulting from
the hiring of new research and development personnel, primarily for the
development of eToken and for our new research and development center that we
opened in connection with the Preview acquisition.

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

General and administrative expenses.General
and administrative expenses consist primarily of compensation for finance and
human resources, allowance for bad debt, good will amortization as well as
professional service expenses. General and administrative expenses decreased to
approximately $7.24 million during 2002 as compared to $8.88 million during
2001. As a percentage of revenues, general and administrative expenses,
decreased to 14.6% in 2002 from 19% during 2001. This decrease in general and
administrative expenses resulted primarily from the fact that goodwill
amortization in 2002 decreased by $1.96 million as compared to 2001. This
decrease in goodwill amortization was due to our adoption of SFAS No. 142,
Goodwill and Other Intangible Assets, whereby we ceased amortizing goodwill
and performed an annual impairment test in accordance with SFAS 142 (see Note 2
to our consolidated financial statements).

Restructuring charges.As a result of
the downturn in the global economic conditions, the decline in overall business
levels and the related impact on our operations, we implemented during 2002 a
worldwide restructuring and cost reduction plan, including at the level of our
subsidiaries. In 2002, we, together with our subsidiaries, recorded expenses of
approximately $1.12 million, out of which $467,000 were included in research and
development expenses, $500,000 in selling and
marketing expenses and $156,000 in general and administrative expenses.
These costs were associated primarily with a reduction in work
force and general reduction in all operating expenses.

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

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

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

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Taxes on income.Taxes on income were
approximately $2.7 million in 2002 compared to an income tax benefit of approximately $347,000 in 2001.
Taxes on income in 2002 were primarily due to an income tax provision from
ongoing operations of approximately $200,000 and due to the increase of the
valuation allowance for deferred tax assets of approximately $2.5 million. The
increase of the valuation allowance is due to the fact that the Companys
ability to use the remaining net operating loss carry forward is dependent upon
future taxable income. Taxes on income in 2001 were primarily due to an income
tax provision from ongoing operations of approximately $139,000 offset by a deferred
tax income benefit of approximately $486,000 regarding carry-forward losses.

B. LIQUIDITY AND CAPITAL RESOURCES

Since
our inception, our operations have been funded through capital contributions,
cash flow from operations and capital gains from sales of marketable
securities. Our business is not capital intensive. Generally, we invest our
excess cash in instruments that are highly liquid.

As
of December 31, 2003, we had cash and cash equivalents and marketable
securities aggregating approximately $19.5 million. Our marketable securities,
as of December 31, 2003, amounted to approximately $1.23 million. Accumulated unrealized
holding gains from available-for-sale securities (which are presented as part
of shareholders equity until realized) amounted to approximately $193,000 as
of December 31, 2003. At December 31, 2003, we had equity investments in Comsec
Information Security Ltd. and Tamir Fishman Ventures II Ltd., Israeli companies
publicly traded on the Tel Aviv Stock Exchange.

Our
operating activities provided cash in the amount of $5.90 million in 2003
primarily due to a decrease in inventories, an
increase in deferred revenues, an increase in accrued expenses and other accounts
payable, and depreciation and
amortization which was partially offset by a decrease in trade receivable and
an increase in deferred income tax. Our operating activities provided cash in
the amount of $4.24 million in 2002 primarily due to a decrease in other accounts receivable and prepaid expenses, a decrease
in inventories, a decrease in deferred income tax, equity in losses of an affiliate, impairment of
investments and depreciation and amortization which was partially offset by our
net operating loss. Our operating activities used cash in the amount of $5
million in 2001 primarily due to our net operating loss and a decrease in
income taxes payable which was offset by an increase in accrued expenses and
other liabilities, equity in losses of an affiliate, impairment of marketable
securities, depreciation and amortization. The improvement in 2003 compared
with 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 $2.58 million in 2003 primarily
due to purchase of property and equipment, investment in and loans to
affiliates. Our investing activities used cash in the amount of $2.51 million
in 2002 primarily due to purchase of property and equipment, investment in and
loans to affiliates. Our investing activities provided cash in the amount of
$3.4 million in 2001 primarily due to proceeds from sale of available for sale
marketable securities, that was offset by purchase of property and equipment,
investment in affiliates and payment for the purchase of assets from Preview
Systems.

Our
financing activities provided cash in the amount of $456,000 in 2003 due to
proceeds from 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.

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We
had working capital of approximately $26.62 million at December 31, 2003, $22.66
million at December 31, 2002 and $24.65 million at December 31, 2001. Our ratio
of current assets to current liabilities was 3.3 at December 31, 2003, 3.4 at
December 31, 2002 and 3.9 at December 31, 2001.

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

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.

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

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 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:

|                                    |  | Payment Due    |       
|----------------------------------- |  | -------------- | ------
|                                    |  |                |       
|Contractual Obligations             |  | Total          |       
|                                    |  |                |       
|                                    |  | (in thousands) |       
|Operating leases (1)                |  | $              | 7,042 
|Purchase obligations (2)            |  | $              | 3,820 
|Other long-term     commitment  (3) |  | $              | 3,410 
|Royalties fee (4)                   |  |                | ------
|                                    |  |                |       
|Total contractual     Obligations   |  | $              | 13,534
|                                    |  |                |       

| | (1) | The operating lease are for
  the premises and vehicles that we lease for our operation, research &
  development, sales & marketing and headquarters.                                                                                                                                                                    
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (2) | We have entered into
  several frame purchase orders. These orders are designed to reduce costs of
  components with high consumption and high production costs. 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 II, LLC (TFV). According to this
  agreement, we committed to invest up to $8.5 million on demand from TFV. We
  based our assumption of the future commitment per year on our past
  experience, since we cannot foresee when the demands will be placed.
| | (4) | In
consideration for the rights and license to use and sell third partys software
product, we committed to pay a license fee of 25% of the net revenues from
sales of the said software product to our partners or customers.                                                                                            

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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.

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:

|Name                      |  | Age |  | Position
  with the Company                                
|------------------------- |  | --- |  | -----------------------------------------------------------
|                          |  |     |  |                                                            
|                          |  |     |  |                                                            
|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                            

|                                                                        
|------------------------------------------------------------------------
|(1)       Member
  of the audit committee
    (2)       Outside Director

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

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

Dr. Menahem Gutterman has been an outside
director since December 31, 2000. Dr. Gutterman 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.

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

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

Avi Barir has been our Vice President of
Software eCommerce 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.

Yanki Margalit and Dany
Margalit are brothers.

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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.

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.

41

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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:

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

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.

42

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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:

|                                |  | Year ended
  December 31, | 
|------------------------------- |  | ------------------------- | 
|                                |  |                           | 
|Activity                        |  | 2003                      | 
|                                |  |                           | 
|Production                      |  | 53                        | 
|Research and
  development      |  | 175                       | 
|Marketing and sales             |  | 77                        | 
|Administration and
  management |  | 46                        | 
|                                |  |                           | 
|Total                           |  | 351                       | 
|                                |  |                           | 

43

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

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

A general practice
followed by us, although not legally required (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.

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.

44

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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.

| | Name and Address                                                                                  |  | Number of
  Shares Owned |  | Percent of
  Shares* |  
| | ------------------------------------------------------------------------------------------------- |  | ------------------------ |  | -------------------- | -
| |                                                                                                   |  |                          |  |                      |  
| |                                                                                                   |  |                          |  |                      |  
| | Yanki
  Margalit
          15 Beit Oved Street
          Tel Aviv 61110, Israel                   |  | 2,184,128                |  | 18.35                | %
| |                                                                                                   |  |                          |  |                      |  
| | Dany
  Margalit
          15 Beit Oved Street
          Tel Aviv 61110, Israel                    |  | 1,093,195                |  | 9.21                 | %
| |                                                                                                   |  |                          |  |                      |  
| | Juniper
  Trading Services
          9 Bermudian Road
          Hamilton Hill
          Bermuda   |  | 1,417,400                |  | 11.94                | %
| |                                                                                                   |  |                          |  |                      |  
| | Diker
  Management, LLC
          745 Fifth Avenue, Suite 1409
          New York, New York 10151 |  | 647,156                  |  | 5.45                 | %

*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.

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.

45

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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.

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 COUNSELNot applicable.

46

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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 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.

47

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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.

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:

|Period              |  | High |       | Low |  
|------------------- |  | ---- | ----- | --- | -
|                    |  |      |       |     |  
|                    |  |      |       |     |  
|May 2004            |  | $    | 27.70 |     | $
|                    |  |      |       |     |  
|April 2004          |  | $    | 26.39 |     | $
|                    |  |      |       |     |  
|March 2004          |  | $    | 19.80 |     | $
|                    |  |      |       |     |  
|February 2004       |  | $    | 17.43 |     | $
|                    |  |      |       |     |  
|January 2004        |  | $    | 12.95 |     | $
|                    |  |      |       |     |  
|December 2003       |  | $    | 9.89  |     | $
|                    |  |      |       |     |  
|November 2003       |  | $    | 9.39  |     | $
|                    |  |      |       |     |  
|October 2003        |  | $    | 10.10 |     | $
|                    |  |      |       |     |  
|September 2003      |  | $    | 7.98  |     | $
|                    |  |      |       |     |  
|First Quarter 2004  |  | $    | 19.80 |     | $
|                    |  |      |       |     |  
|Fourth Quarter 2003 |  | $    | 10.10 |     | $
|                    |  |      |       |     |  
|Third Quarter 2003  |  | $    | 7.98  |     | $
|                    |  |      |       |     |  
|Second Quarter 2003 |  | $    | 4.10  |     | $
|                    |  |      |       |     |  
|First Quarter 2003  |  | $    | 3.38  |     | $
|                    |  |      |       |     |  
|Fourth Quarter 2002 |  | $    | 2.67  |     | $
|                    |  |      |       |     |  
|Third Quarter 2002  |  | $    | 2.35  |     | $
|                    |  |      |       |     |  
|Second Quarter 2002 |  | $    | 3.80  |     | $
|                    |  |      |       |     |  
|First Quarter 2002  |  | $    | 3.86  |     | $
|                    |  |      |       |     |  
|2003                |  | $    | 10.10 |     | $
|                    |  |      |       |     |  
|2002                |  | $    | 3.86  |     | $
|                    |  |      |       |     |  
|2001                |  | $    | 5.91  |     | $
|                    |  |      |       |     |  
|2000                |  | $    | 44.75 |     | $
|                    |  |      |       |     |  
|1999                |  | $    | 19.31 |     | $

48

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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 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.

49

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Item
10.          Additional
Information

A. SHARE CAPITALNot 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.

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:

50

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

According to the Companies Law,
the disclosure requirements discussed above also apply to a controlling
shareholder of a public company. In general, extraordinary transactions with a
controlling shareholder or in which a controlling shareholder has a personal
interest, and agreements relating to employment and compensation terms of a
controlling shareholder require the approval of the audit committee, the board
of directors and the shareholders of the company. The term controlling
shareholder is defined for these purposes as a shareholder who has the ability
to direct the activities of a company, other than if this power derives solely
from the shareholders position on the board of directors or any other position
with the company. The definition also includes shareholders that hold 25% or
more of the voting rights if no other shareholder owns more than 50% of the
voting rights in the company. The shareholder approval must 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:

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

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

51

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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:

| |  | amendments to our Articles of Association (other
  than modifications of shareholders 
  rights as mentioned above);
| | - | --------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                     
| |  | appointment or termination of our auditors;                                                                         
| |   |                                                                                                                     
| |  | appointment and dismissal of directors;                                                                             
| |   |                                                                                                                     
| |  | approval of acts and transactions requiring general
  meeting approval under the Companies Law;                     
| |   |                                                                                                                     
| |  | increase or reduction of our authorized share
  capital or the rights of shareholders or a class of shareholders;   

52

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| |  | any merger; and                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                                                                              
| |  | the exercise of the board of directors powers by a
  general meeting, if the board of directors is unable to exercise its powers
  and the exercise of any of its powers is vital for our proper management.

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

Our 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:
| |                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                         
| | 3.     indemnify
  an office holder of the company for:                                                                                                                                                                 
| |                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                         

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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:

| |  | a breach of his fiduciary
  duty, except to the extent described above;                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                              
| |  | 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;
| |   |                                                                                                                                                              
| |  | an act or omission
  committed with the intent to unlawfully realize personal gain; or                                                                       
| |   |                                                                                                                                                              
| |  | 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.

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.

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D. EXCHANGE CONTROLS

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

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

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.

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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:

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

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

In addition, a company owning
an Approved Enterprise approved after April 1, 1986 (or prior thereto provided
no government grants or loans had previously been granted regarding such
enterprise) may elect (as is the case with us) to forego certain government
grants extended to Approved Enterprises in return for an alternative package
of tax benefits (the Alternative Package). Under the Alternative Package, a
companys undistributed income derived from an Approved Enterprise will be
exempt from 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.

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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:

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

Taxation under Inflationary Conditions

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

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

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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.

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.

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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.

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.

59

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F. DIVIDENDS AND PAYING AGENTS

Not
applicable.

G. STATEMENTS BY EXPERTS

Not
applicable.

H. DOCUMENTS ON DISPLAY

We
are required to file reports and other information with the SEC under the
Securities Exchange Act of 1934 and the regulations thereunder applicable to
foreign private issuers. Reports and other information filed by us with the SEC
may be inspected and copied at the SECs public reference facilities described
below. Although as a foreign private issuer we are not required to file
periodic information as frequently or as promptly as United States companies,
we generally do publicly announce our quarterly and year-end results promptly
and file periodic information with the SEC under cover of Form 6-K. As a
foreign private issuer, we are also exempt from the rules under the Exchange
Act prescribing the furnishing and content of proxy statements and our
officers, directors and principal shareholders are exempt from the reporting
and other provisions in Section 16 of the Exchange Act.You may review a copy of our filings with the SEC, including any
exhibits and schedules, at the SECs public reference facilities in Room 1024,
Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549 and at the
regional offices of the SEC located at the Northwestern Atrium Center, 500 West
Madison Street, Suite 1400, Chicago, Illinois 60661. You may also obtain copies
of such materials from the Public Reference Section of the SEC, Room 1024,
Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed
rates. You may call the SEC at 1-800-SEC-0330 for further information on the
public reference rooms. In addition, such information concerning our company
can be inspected and copied at the offices of the National Association of
Securities Dealers, Inc., 9513 Key West Avenue, Rockville, Maryland 20850 and
at the offices of the Israel Securities Authority at 22 Kanfei Nesharim St.,
Jerusalem, Israel. As a foreign private issuer, all documents which were filed
after November 4, 2002 on the SECs EDGAR system will be available for
retrieval on the SECs website at www.sec.gov. You may read and copy any
reports, statements or other information that we file with the SEC at the SEC
facilities listed above. These SEC filings are also available to the public
from commercial document retrieval services. We also generally make available
on our own Web site all our quarterly and year-end financial statements as well
as other information.

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

I. SUBSIDIARY INFORMATION
Not
applicable.

Item
11.          Quantitative
and Qualitive Disclosures About Market Risk

Risks

Interest Rate Risks

Our exposure to market
risk for changes in interest rates relates primarily to our cash equivalents
and investment portfolio. We maintain a strict investment policy, which ensures
the safety and preservation of our invested funds by limiting default risk,
market risk and reinvestment risk. Our cash and cash equivalent as of December
31, 2003, consists primarily of demand deposits and money market funds held by
institutions in the United States, Israel, The UK, The Netherlands, Germany,
Japan and France. Due to the nature of our cash and cash equivalents and
short-term investments, we have concluded that we do not have material market
risk exposure.

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Foreign
Currency Exchange and Inflation Risks

Since the majority of our
revenues are paid in or linked to U.S. dollars and Euro, we believe that the
effects of inflation and fluctuations in the NIS/U.S. dollar and the Euro/ U.S.
dollar exchange rate may result in a material effect on our revenues. Inflation
in Israel, NIS/U.S. dollar and the Euro/ U.S. dollar exchange rate
fluctuations, have some influence on our expenses, which un turn affect our net
income. The cost of Israel operations, as expressed in U.S. dollars, is
influenced by the extent to which any increase in the rate of inflation in
Israel is not offset, or is offset on a lagging basis, by a devaluation of the
NIS in relation to the U.S. dollar.

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

Equity Investments

We have investments in marketable
equity securities of publicly traded companies. These investments, as of December 31,
2003, were considered available-for-sale, with any unrealized gains or losses deferred as
a component of stockholders equity accumulated other comprehensive income (loss). At
December 31, 2003, the fair market value of these investments was $1,129,000.

Together with our US subsidiary we
have committed to invest approximately $8.5 million in Tamir Fishman Ventures II (Israel)
L.P. and in a Delaware limited partnership related to Tamir Fishman Ventures II LLC. As of
December 31, 2003 we had invested approximately $5.12 million. Together with our US
subsidiary, as of May 31, 2004 we have invested a total of $8.54 million in Tamir Fishman
Ventures II (Israel) L.P. and in a Delaware limited partnership related to Tamir Fishman
Ventures II LLC, which represents more than half of our total commitment.

Item
12.          Descriptions
of Securities Other than Equity Securities

Not Applicable

PART II

Item
13.          Defaults,
Dividend Arrearages and Delinquencies

None.

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

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.

61

---

---

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.

|                      |  | 2003 |         | 2002 |  
|--------------------- |  | ---- | ------- | ---- | -
|                      |  |      |         |      |  
|Audit Fees(1)         |  | $    | 117,663 |      | $
|Audit-Related Fees(2) |  | $    | 57,749  |      | $
|Tax Fees(3)           |  | $    | 153,522 |      | $

|(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.

62

---

---

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

63

---

---

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.                                         
|     |                                                                                                                                     
|1.3  | Memorandum of Association of the registrant.(1)(2)                                                                                  
|     |                                                                                                                                     
|4.1  | Asset Purchase Agreement dated as of May 17, 2001,
  by and between Preview Systems Inc. and the registrant. (3)                    
|     |                                                                                                                                     
|4.2  | Strategic Investor Agreement dated as of February
  21, 2000, by and between the registrant and Tamir Fishman Ventures. (3)         
|     |                                                                                                                                     
|4.3  | Subscription by Aladdin for partnership units in
  Tamir Fishman Ventures. (3)                                                      
|     |                                                                                                                                     
|4.4  | Share Purchase Agreement dated as of February 22,
  2001, by and between the registrant and Tamir Fishman Venture Capital Ltd.
  (3)
|     |                                                                                                                                     
|4.5  | Form of Indemnification Agreement between the
  registrant and each of the members of its board of directors and its
  officers.    
|     |                                                                                                                                     
|4.6  | Convertible Loan Agreement dated as of April 29,
  2004, by and between C-Signature Ltd. and the registrant. (4)                    
|     |                                                                                                                                     
|8.1  | List of subsidiaries.                                                                                                               
|     |                                                                                                                                     
|10.1 | Consent letter from Kost, Forer, Gabbay &
  Kasierer.                                                                               
|     |                                                                                                                                     
|10.2 | Consent letter from Blick Rothenberg.                                                                                               
|     |                                                                                                                                     
|11.  | Code of Ethics                                                                                                                      
|     |                                                                                                                                     
|12.1 | Certification by Chief Executive Officer pursuant to
  section 302 of the Sarbanes-Oxley Act of 2002.                               
|     |                                                                                                                                     
|12.2 | Certification by Chief Financial Officer pursuant to
  section 302 of the Sarbanes-Oxley Act of 2002.                               
|     |                                                                                                                                     
|13.1 | Certification by Chief Executive Officer pursuant to
  section 906 of the Sarbanes-Oxley Act of 2002.                               
|     |                                                                                                                                     
|13.2 | Certification by Chief Financial Officer pursuant to
  section 906 of the Sarbanes-Oxley Act of 2002.                               

64

---

---

---

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

65

---

---

SIGNATURES

Pursuant to the requirements
of Section 12 of the Securities Exchange Act of 1934, the registrant certifies
that it meets all the requirements for filing on Form 20-F and has duly caused
and authorized the undersigned to sign this annual report on its behalf in the
City of Tel Aviv, State of Israel, on this 28 day of June 2004.

ALADDIN
KNOWLEDGE SYSTEMS LTD.

| | By:                           | /s/ Yanki Margalit | 
| | ----------------------------- | ------------------ | 
| |                               |                    | 
| | Yanki Margalit               
| |                              
| | Chief Executive Officer
  and
| |                              
| | Chairman of the Board        

66



---

---

ALADDIN
KNOWLEDGE SYSTEMS LTD. AND ITS SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2003

IN U.S. DOLLARS

INDEX

|                                                | Page  
|----------------------------------------------- | ------
|                                                |       
|                                                |       
|Report of Independent Auditors                  | 2     
|                                                |       
|Consolidated Balance Sheets                     | 3 - 4 
|                                                |       
|Consolidated Statements of Operations           | 5     
|                                                |       
|Statements of Changes in Shareholders
  Equity | 6     
|                                                |       
|Consolidated Statements of Cash Flows           | 7 - 8 
|                                                |       
|Notes to Consolidated Financial Statements      | 9 - 35

- - - - - - - -

---

---



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
Knowledge Systems 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 reports have been furnished to
us, and our opinion, insofar as it relates to the data included for oversight
Board (United States) Aladdin Knowledge Systems Western Europe Ltd., is based
solely on the reports 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 reports 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   | KOST FORER
  GABBAY & KASIERER  
|------------------ | --------------------------------
|January 22,
  2004 | A Member of Ernst & Young Global

- 2 -

---

---

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

|                                                                                                             |  | December 31, |       
|------------------------------------------------------------------------------------------------------------ |  | ------------ | ------
|                                                                                                             |  |              |       
|                                                                                                             |  | 2002         |       
|                                                                                                             |  |              |       
|ASSETS                                                                                                       |  |              |       
|                                                                                                             |  |              |       
|CURRENT
  ASSETS:                                                                                            |  |              |       
|Cash
  and cash equivalents                                                                                  |  | $            | 14,235
|Marketable
  securities (Note 3)                                                                             |  |              | 860   
|Trade
  receivables (net of allowance for doubtful accounts - $ 991 in 2002
            and $ 972 in
  2003) |  |              | 8,094 
|Other
  accounts receivable and prepaid expenses (Note 4)                                                    |  |              | 2,177 
|Deferred  income taxes (Note 13g)                                                                            |  |              | 469   
|Inventories
  (Note 5)                                                                                       |  |              | 6,269 
|                                                                                                             |  |              |       
|                                                                                                             |  |              |       
|Total current
  assets                                                                                       |  |              | 32,104
|                                                                                                             |  |              |       
|                                                                                                             |  |              |       
|LONG-TERM
  INVESTMENTS:                                                                                     |  |              |       
|Investment
  in affiliate (Note 6)                                                                           |  |              | -     
|Investment
  in other company (Note 7)                                                                       |  |              | 2,252 
|Severance
  pay fund                                                                                         |  |              | 1,957 
|                                                                                                             |  |              |       
|                                                                                                             |  |              |       
|Total long-term
  investments                                                                                |  |              | 4,209 
|                                                                                                             |  |              |       
|                                                                                                             |  |              |       
|PROPERTY AND
  EQUIPMENT, NET (Note 8)                                                                       |  |              | 3,478 
|                                                                                                             |  |              |       
|                                                                                                             |  |              |       
|OTHER
  ASSETS, NET                                                                                          |  |              |       
|Intangible
  assets, net (Note 9)                                                                            |  |              | 752   
|Goodwill
  (Note 10)                                                                                         |  |              | 7,281 
|Deferred  income taxes (Note 13g)                                                                            |  |              | 715   
|                                                                                                             |  |              |       
|                                                                                                             |  |              |       
|Total other
  assets                                                                                         |  |              | 8,748 
|                                                                                                             |  |              |       
|                                                                                                             |  |              |       
|Total assets                                                                                                 |  | $            | 48,539
|                                                                                                             |  |              |       

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

- 3 -

---

---

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

|                                                                                                                                                                                                                                                                                                                   |  | December
  31, |       
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------- | ------
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|                                                                                                                                                                                                                                                                                                                   |  | 2002           |       
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|LIABILITIES
  AND SHAREHOLDERS EQUITY                                                                                                                                                                                                                                                                             |  |                |       
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|CURRENT
  LIABILITIES:                                                                                                                                                                                                                                                                                             |  |                |       
|Trade
  payables                                                                                                                                                                                                                                                                                                   |  | $              | 2,398 
|Deferred
  revenues                                                                                                                                                                                                                                                                                                |  |                | 2,323 
|Accrued
  expenses and other accounts payable (Note 11)                                                                                                                                                                                                                                                            |  |                | 4,719 
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|Total current
  liabilities                                                                                                                                                                                                                                                                                        |  |                | 9,440 
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|ACCRUED SEVERANCE
  PAY                                                                                                                                                                                                                                                                                            |  |                | 2,772 
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|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    
|Additional
  paid-in capital                                                                                                                                                                                                                                                                                       |  |                | 36,147
|Treasury
  shares                                                                                                                                                                                                                                                                                                  |  |                | (1,164
|Accumulated
  other comprehensive loss                                                                                                                                                                                                                                                                             |  |                | (4,529
|Retained
  earnings                                                                                                                                                                                                                                                                                                |  |                | 5,836 
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|Total shareholders
  equity                                                                                                                                                                                                                                                                                       |  |                | 36,327
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|                                                                                                                                                                                                                                                                                                                   |  |                |       
|Total liabilities
  and shareholders equity                                                                                                                                                                                                                                                                       |  | $              | 48,539
|                                                                                                                                                                                                                                                                                                                   |  |                |       

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

- 4 -

---

---

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

|                                                        |  | Year ended
  December 31, |        
|------------------------------------------------------- |  | ------------------------- | -------
|                                                        |  |                           |        
|                                                        |  | 2001                      |        
|                                                        |  |                           |        
|Revenues
  (Note 16):                                   |  |                           |        
|Software
  security                                     |  | $                         | 38,421 
|Enterprise
  security                                   |  |                           | 8,192  
|                                                        |  |                           |        
|                                                        |  |                           |        
|Total revenues                                          |  |                           | 46,613 
|                                                        |  |                           |        
|                                                        |  |                           |        
|Cost of
  revenues:                                     |  |                           |        
|Software
  security                                     |  |                           | 7,753  
|Enterprise
  security                                   |  |                           | 1,567  
|                                                        |  |                           |        
|                                                        |  |                           |        
|Total cost
  of revenues                                |  |                           | 9,320  
|                                                        |  |                           |        
|                                                        |  |                           |        
|Gross profit                                            |  |                           | 37,293 
|                                                        |  |                           |        
|                                                        |  |                           |        
|Operating
  expenses:                                   |  |                           |        
|Research
  and development (Note 1c)                    |  |                           | 11,043 
|Selling
  and marketing (Note 1c)                       |  |                           | 22,474 
|General
  and administrative (Note 1c)                  |  |                           | 8,877  
|Impairment
  of intangible assets (Note 2)              |  |                           | 5,211  
|                                                        |  |                           |        
|                                                        |  |                           |        
|Total operating
  expenses                              |  |                           | 47,605 
|                                                        |  |                           |        
|                                                        |  |                           |        
|Operating
  income (loss)                               |  |                           | (10,312
|Financial
  income (expenses), net (Note 17a)           |  |                           | (410   
|Other
  expenses, net (Note 17b)                        |  |                           | (3,372 
|                                                        |  |                           |        
|                                                        |  |                           |        
|Income
  (loss) before taxes on income                  |  |                           | (14,094
|Taxes on
  income (Note 13)                             |  |                           | (347   
|                                                        |  |                           |        
|                                                        |  |                           |        
|Income
  (loss) before equity in losses of an affiliate |  |                           | (13,747
|Equity in
  losses of an affiliate                      |  |                           | (1,168 
|                                                        |  |                           |        
|                                                        |  |                           |        
|Net income
  (loss)                                     |  | $                         | (14,915
|                                                        |  |                           |        
|                                                        |  |                           |        
|Net earnings
  (loss) per share (Note 17c):             |  |                           |        
|Basic                                                   |  | $                         | (1.32  
|                                                        |  |                           |        
|                                                        |  |                           |        
|Diluted                                                 |  | $                         | (1.32  
|                                                        |  |                           |        

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

- 5 -

---

---

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

|                                                                                                                                            |  | Share
  capital |    | Additional
  paid-in
  capital |   | Treasury
  shares |  | Accumulated
  other
  comprehensive
  loss |        | Retained
  earnings |  | Total
  comprehensive
  income (loss) |            | Total
  shareholders
  equity | 
|------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------- | -- | ------------------------------ | - | ----------------- |  | ------------------------------------------ | ------ | ------------------- |  | ------------------------------------- | ---------- | ------------------------------ | 
|                                                                                                                                            |  |                 |    |                                |   |                   |  |                                            |        |                     |  |                                       |            |                                | 
|                                                                                                                                            |  |                 |    |                                |   |                   |  |                                            |        |                     |  |                                       |            |                                | 
|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 | )                              | 
|                                                                                                                                            |  |                 |    |                                |   |                   |  |                                            |        |                     |  |                                       |            |                                | 

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

| | 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 | )
| |                                                                                                   |  |   |        |  

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

- 6 -

---

---

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

|                                                                                                                            |  | Year ended
  December 31, |        
|--------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | -------
|                                                                                                                            |  |                           |        
|                                                                                                                            |  | 2001                      |        
|                                                                                                                            |  |                           |        
|Cash flows
  from operating activities:                                                                                     |  |                           |        
|                                                                                                                            |  |                           |        
|Net
  income (loss)                                                                                                         |  | $                         | (14,915
|Adjustments
  required to reconcile net income (loss) to net
            cash provided by
  (used in) operating activities: |  |                           |        
|Depreciation
  and amortization                                                                                             |  |                           | 4,415  
|Impairment
  of intangible assets                                                                                           |  |                           | 5,211  
|Impairment
  of investment in FAST                                                                                          |  |                           | 3,350  
|Equity
  in losses of an affiliate                                                                                          |  |                           | 1,168  
|Impairment
  of investment in other company                                                                                 |  |                           | -      
|Increase
  in accrued severance pay, net                                                                                    |  |                           | 196    
|Impairment
  of available-for-sale marketable securities                                                                    |  |                           | 1,004  
|Deferred
  income taxes, net                                                                                                |  |                           | (486   
|Decrease
  (increase) in trade receivables                                                                                  |  |                           | 3      
|Decrease
  (increase) in inventories                                                                                        |  |                           | (982   
|Decrease
  in other accounts receivable and prepaid expenses                                                                |  |                           | 150    
|Increase
  (decrease) in trade payables                                                                                     |  |                           | (686   
|Increase
  in deferred revenues                                                                                             |  |                           | 365    
|Increase
  (decrease) in accrued expenses and other accounts
                 payable                                       |  |                           | (3,777 
|Other                                                                                                                       |  |                           | (43    
|                                                                                                                            |  |                           |        
|                                                                                                                            |  |                           |        
|Net cash
  provided by (used in) operating activities                                                                       |  |                           | (5,027 
|                                                                                                                            |  |                           |        
|                                                                                                                            |  |                           |        
|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   
|Proceeds
  from long-term loans to an affiliate                                                                             |  |                           | 250    
|Purchase
  of property and equipment                                                                                        |  |                           | (1,235 
|Proceeds
  from sale of property and equipment                                                                              |  |                           | 31     
|Purchase
  of intangible assets                                                                                             |  |                           | -      
|Investment
  in other company                                                                                               |  |                           | (1,241 
|Payment
  for the purchase of Preview (1)                                                                                   |  |                           | (5,239 
|                                                                                                                            |  |                           |        
|                                                                                                                            |  |                           |        
|Net cash
  provided by (used in) investing activities                                                                       |  |                           | 3,420  
|                                                                                                                            |  |                           |        

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

- 7 -

---

---

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

|                                                                                                                  |  | Year ended
  December 31, |       
|----------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------
|                                                                                                                  |  |                           |       
|                                                                                                                  |  | 2001                      |       
|                                                                                                                  |  |                           |       
|                                                                                                                  |  |                           |       
|Cash flows
  from financing activities:                                                                           |  |                           |       
|                                                                                                                  |  |                           |       
|Proceeds
  from exercise of options                                                                               |  |                           | -     
|Purchase
  of Treasury shares                                                                                     |  |                           | (261  
|                                                                                                                  |  |                           |       
|                                                                                                                  |  |                           |       
|Net cash
  provided by (used in) financing activities                                                             |  |                           | (261  
|                                                                                                                  |  |                           |       
|                                                                                                                  |  |                           |       
|Effect of
  exchange rate on cash and cash equivalents                                                            |  |                           | (271  
|                                                                                                                  |  |                           |       
|                                                                                                                  |  |                           |       
|Increase
  (decrease) in cash and cash equivalents                                                                |  |                           | (2,139
|Cash and
  cash equivalents at the beginning of the year                                                          |  |                           | 14,345
|                                                                                                                  |  |                           |       
|                                                                                                                  |  |                           |       
|Cash and
  cash equivalents at the end of the year                                                                |  | $                         | 12,206
|                                                                                                                  |  |                           |       
|                                                                                                                  |  |                           |       
|Supplemental
  disclosure:                                                                                        |  |                           |       
|                                                                                                                  |  |                           |       
|Income
  taxes paid during the year                                                                               |  | $                         | 3,200 
|                                                                                                                  |  |                           |       
|                                                                                                                  |  |                           |       
|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.              |  | $                         | -     
|                                                                                                                  |  |                           |       
|                                                                                                                  |  |                           |       
|Conversion
  of balance in trade receivable due from an
            affiliate to
  long-term loan to an affiliate |  | $                         | -     
|                                                                                                                  |  |                           |       
|                                                                                                                  |  |                           |       
|(1)          Payment
  for purchase of Preview (see Note 1b):                                                     |  |                           |       
|                                                                                                                  |  |                           |       
|Fair
  value of assets acquired and liabilities assumed at
                      the
  date of acquisition:       |  |                           |       
|                                                                                                                  |  |                           |       
|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 
|                                                                                                                  |  |                           |       

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

- 8 -

---

---

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

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

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

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

- 9 -

---

---

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

|NOTE 1:- | GENERAL (Cont.)
|-------- | ---------------
|         |                
|         | c.             
|         |                
|         |                
|         |                
|         |                

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

|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.                                                                                                                                                                                                                                                                                                      

- 10 -

---

---

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

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | 2.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Principles of consolidation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | The
  consolidated financial statements include the accounts of the Company and its
  wholly-owned subsidiaries. Intercompany transactions and balances, including
  profits from intercompany sales not yet realized outside the Group, have been
  eliminated upon consolidation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Cash equivalents:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Cash equivalents
  include short-term, highly liquid investments that are readily convertible to
  cash with maturities of three months or less at the date acquired.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | 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.

- 11 -

---

---

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

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|-------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | 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).                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | 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 managements 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:                                                                                                                                                                                                                                                                                                                                                                                                   

| |                                      |  | %                          | 
| | ------------------------------------ |  | -------------------------- | 
| |                                      |  |                            | 
| |                                      |  |                            | 
| | Computers
  and peripheral equipment |  | 15 - 33                    | 
| | Office
  furniture and equipment     |  | 6 - 20                     | 
| | Motor
  vehicles                     |  | 15                         | 
| | Leasehold
  improvements             |  | Over the term of the lease | 

- 12 -

---

---

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

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | 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.

- 13 -

---

---

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

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|-------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | 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.                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | 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
  generates revenues from licensing the rights to use its software and from
  sales of its products directly to end-users and indirectly mostly through
  value-added resellers, original equipment manufacturers and independent
  distributors (all of them are considered end users) from the sale of products
  and maintenance.                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | Revenues
  from product sales are recognized in accordance with SAB No.104 when delivery
  has occurred, persuasive evidence of an arrangement exists, the vendors fee
  is fixed or determinable, no further obligation exists, and collectibility is
  probable                                                                                                                                                                                                                                                                                                                                                                                                                                              

- 14 -

---

---

|                                                     
|-----------------------------------------------------
|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
  accounts for software sales in accordance with Statement of Position No.
  97-2, Software Revenue Recognition, as amended (SOP No. 97-2). SOP No.
  97-2 generally requires revenue earned on software arrangements involving
  multiple elements to be allocated to each element based on the relative fair
  value of the elements. In addition the Company has adopted Statement of
  Position 98-9, Modification of SOP No. 97-2, Software Revenue Recognition
  with Respect to Certain Transactions, (SOP No. 98-9). SOP No. 98-9
  requires that revenue be recognized under the residual method when Vendor
  Specific Objective Evidence (VSOE) of fair value exists for all undelivered
  elements and VSOE does not exist for all of the delivered elements. Under the
  residual method any discount in the arrangement is allocated to the delivered
  elements.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Revenue from
  license fees is 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Maintenance
  and support revenue included in multiple element arrangements 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | In November
  2002, Emerging Issues Task Force reached a consensus on Issue No. 00-21
  Revenue Arrangements with Multiple Deliverables, (EITF No. 00-21) which
  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 No. 00-21 applied to revenue arrangements
  entered into in fiscal periods beginning after June 15, 2003. The adoption of
  EITF No. 00-21 did not have a material impact upon the Companys financial
  position, cash flows or results of operations.                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | Deferred
  revenues are comprised of payments received for maintenance and support which
  are not recorded until payment is collected and are recognized as revenues
  over the term of the arrangement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | 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.                                                                                                                                                                                                                                                                                               

- 15 -

---

---

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

|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         | 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.                                                                                                                                          

- 16 -

---

---

|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:                                                                                                                                                                                                                                                                                                                                                                                                                                           

| |                                             |  | 2001      |  | 2002      |  | 2003        | 
| | ------------------------------------------- |  | --------- |  | --------- |  | ----------- | 
| |                                             |  |           |  |           |  |             | 
| |                                             |  |           |  |           |  |             | 
| | Dividend yield                              |  | 0%        |  | 0%        |  | 0%          | 
| | Expected volatility                         |  | 53.6%     |  | 25.8%     |  | 65%         | 
| | Risk-free interest                          |  | 2%        |  | 1. 5%     |  | 1%          | 
| | Expected life of up to                      |  | 5
  years |  | 5
  years |  | 4.5
  years | 
| |                                             |  |           |  |           |  |             | 
| | Pro forma information under SFAS No.
  123: |  |           |  |           |  |             | 

| |                                                                       |  | Year ended December 31, |        
| | --------------------------------------------------------------------- |  | ----------------------- | -------
| |                                                                       |  |                         |        
| |                                                                       |  | 2001                    |        
| |                                                                       |  |                         |        
| |                                                                       |  |                         |        
| | Net
  income (loss) available to Ordinary shares - as
       reported |  | $                       | (14,915
| | Deduct:
  stock-based employee compensation - fair
       value       |  |                         | 491    
| |                                                                       |  |                         |        
| | Pro
  forma:                                                          |  |                         |        
| |                                                                       |  |                         |        
| | Net
  income (loss)                                                   |  | $                       | (15,406
| |                                                                       |  |                         |        
| | Earnings
  per share:                                                 |  |                         |        
| |                                                                       |  |                         |        
| | Earnings
  (loss) as reported                                         |  | $                       | (1.32  
| |                                                                       |  |                         |        
| | Diluted
  earnings (loss) as reported                                 |  | $                       | (1.32  
| |                                                                       |  |                         |        
| | Pro
  forma basic earnings (loss)                                     |  | $                       | (1.37  
| |                                                                       |  |                         |        
| | Pro
  forma diluted earnings (loss)                                   |  | $                       | (1.37  
| |                                                                       |  |                         |        

- 17 -

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---

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

|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.

- 18 -

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---

|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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

- 19 -

---

---

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

|NOTE 3:- | MARKETABLE SECURITIES
|-------- | ---------------------

| |                     |  | December 31, 2002 |     | December 31, 2003          | 
| | ------------------- |  | ----------------- | --- | -------------------------- | 
| |                     |  |                   |     |                            | 
| |                     |  | Cost              |     | Gross
  unrealized
  gains | 
| |                     |  |                   |     |                            | 
| | Available-for-sale: |  |                   |     |                            | 
| | Equity
  securities |  | $                 | 927 |                            | 
| |                     |  |                   |     |                            | 

|         | 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                                                                                                                                                                                                                                                                                                                                           

| |                          |  | December 31, |      
| | ------------------------ |  | ------------ | -----
| |                          |  |              |      
| |                          |  | 2002         |      
| |                          |  |              |      
| |                          |  |              |      
| | Loans
  to employees (1) |  | $            | 267  
| | Prepaid
  expenses       |  |              | 1,187
| | Government
  authorities |  |              | 268  
| | Unbilled
  receivables   |  |              | 155  
| | Other                    |  |              | 300  
| |                          |  |              |      
| |                          |  |              |      
| |                          |  | $            | 2,177
| |                          |  |              |      

| | (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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

- 20 -

---

---

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

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

| |                                     |  | December 31, |      
| | ----------------------------------- |  | ------------ | -----
| |                                     |  |              |      
| |                                     |  | 2002         |      
| |                                     |  |              |      
| |                                     |  |              |      
| | Raw
  materials, parts and supplies |  | $            | 2,914
| | Work-in-progress                    |  |              | 616  
| | Finished
  products                 |  |              | 2,739
| |                                     |  |              |      
| |                                     |  |              |      
| |                                     |  | $            | 6,269
| |                                     |  |              |      

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

| | 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 |  | $ | -      |   | $ | -      |  
| |                                                                              |  |   |        |   |   |        |  

| | (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.

- 21 -

---

---

|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                                                                                                                                                                                                                                                                                                                                                            

| |                                      |  | December 31, |       
| | ------------------------------------ |  | ------------ | ------
| |                                      |  |              |       
| |                                      |  | 2002         |       
| |                                      |  |              |       
| | Cost:                                |  |              |       
| | Computers
  and peripheral equipment |  | $            | 10,598
| | Office
  furniture and equipment     |  |              | 2,469 
| | Motor
  vehicles                     |  |              | 742   
| | Leasehold
  improvements             |  |              | 1,307 
| |                                      |  |              |       
| |                                      |  |              |       
| |                                      |  |              | 15,116
| |                                      |  |              |       
| | Accumulated
  depreciation:          |  |              |       
| | Computers
  and peripheral equipment |  |              | 8,834 
| | Office
  furniture and equipment     |  |              | 1,715 
| | Motor
  vehicles                     |  |              | 393   
| | Leasehold
  improvements             |  |              | 696   
| |                                      |  |              |       
| |                                      |  |              |       
| |                                      |  |              | 11,638
| |                                      |  |              |       
| |                                      |  |              |       
| | Depreciated
  cost                   |  | $            | 3,478 
| |                                      |  |              |       

|         | 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.                                                                                                                                   

| |                            |  | December 31, |      
| | -------------------------- |  | ------------ | -----
| |                            |  |              |      
| |                            |  | 2002         |      
| |                            |  |              |      
| |                            |  |              |      
| | Cost                       |  | $            | 1,054
| | Accumulated
  amortization |  |              | 302  
| |                            |  |              |      
| |                            |  |              |      
| |                            |  | $            | 752  
| |                            |  |              |      

- 22 -

---

---

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

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

| |      |  |   |     | 
| | ---- |  | - | --- | 
| | 2004 |  | $ | 208 | 
| | 2005 |  |   | 208 | 
| | 2006 |  |   | 115 | 
| |      |  |   |     | 
| |      |  |   |     | 
| |      |  | $ | 531 | 
| |      |  |   |     | 

|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:

| |                                      |  | Year ended December 31, |        
| | ------------------------------------ |  | ----------------------- | -------
| |                                      |  |                         |        
| |                                      |  | 2001                    |        
| |                                      |  |                         |        
| |                                      |  |                         |        
| | Reported
  net income (loss)         |  | $                       | (14,915
| | Goodwill
  amortization              |  |                         | 2,172  
| |                                      |  |                         |        
| |                                      |  |                         |        
| | Adjusted
  net income (loss)         |  | $                       | (12,743
| |                                      |  |                         |        
| |                                      |  |                         |        
| | Basic
  earnings (loss) per share:   |  |                         |        
| |                                      |  |                         |        
| | Reported
  net earnings (loss)       |  | $                       | (1.32  
| | Goodwill
  amortization              |  |                         | 0.20   
| |                                      |  |                         |        
| |                                      |  |                         |        
| | Adjusted
  net income (loss)         |  | $                       | (1.12  
| |                                      |  |                         |        
| |                                      |  |                         |        
| | Diluted
  earnings (loss) per share: |  |                         |        
| |                                      |  |                         |        
| | Reported
  net income (loss)         |  | $                       | (1.32  
| | Goodwill
  amortization              |  |                         | 0.20   
| |                                      |  |                         |        
| |                                      |  |                         |        
| | Adjusted
  net income (loss)         |  | $                       | (1.12  
| |                                      |  |                         |        

- 23 -

---

---

|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
|--------- | ----------------------------------------------

| |                                            |  | December 31, |      
| | ------------------------------------------ |  | ------------ | -----
| |                                            |  |              |      
| |                                            |  | 2002         |      
| |                                            |  |              |      
| |                                            |  |              |      
| | Employees
  and payroll accruals           |  | $            | 2,626
| | Accrued
  expenses                         |  |              | 778  
| | Amount
  collected on behalf of a customer |  |              | 425  
| | Income
  taxes payable                     |  |              | 457  
| | Other                                      |  |              | 433  
| |                                            |  |              |      
| |                                            |  |              |      
| |                                            |  | $            | 4,719
| |                                            |  |              |      

|NOTE 12:- | COMMITMENTS AND CONTINGENT LIABILITIES
|--------- | --------------------------------------
|          |                                       
|          | a.                                    
|          |                                       
|          |                                       
|          |                                       
|          |                                       

| |      |  | Year ended December 31, |      
| | ---- |  | ----------------------- | -----
| |      |  |                         |      
| |      |  | Facilities              |      
| |      |  |                         |      
| |      |  |                         |      
| | 2004 |  | $                       | 1,574
| | 2005 |  |                         | 1,012
| | 2006 |  |                         | 728  
| | 2007 |  |                         | 472  
| | 2008 |  |                         | 304  
| |      |  |                         |      
| |      |  |                         |      
| |      |  | $                       | 4,090
| |      |  |                         |      

| |  | 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.

- 24 -

---

---

|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.                                            
|          |                                               
|          |                                               
|          |                                               
|          | c.                                            
|          |                                               
|          |                                               
|          |                                               
|NOTE 13:- | TAXES ON INCOME                               
|          |                                               
|          | a.                                            
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               

- 25 -

---

---

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

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

- 26 -

---

---

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

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

| | 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:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

| |          |  | Year ended December 31, |        
| | -------- |  | ----------------------- | -------
| |          |  |                         |        
| |          |  | 2001                    |        
| |          |  |                         |        
| | Domestic |  | $                       | (2,001 
| | Foreign  |  |                         | (12,093
| |          |  |                         |        
| |          |  |                         |        
| |          |  | $                       | (14,094
| |          |  |                         |        

- 27 -

---

---

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

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

| |                  |  | Year ended December 31, |     
| | ---------------- |  | ----------------------- | ----
| |                  |  |                         |     
| |                  |  | 2001                    |     
| |                  |  |                         |     
| |                  |  |                         |     
| | Current
  taxes  |  | $                       | 139 
| | Deferred
  taxes |  |                         | (486
| |                  |  |                         |     
| |                  |  |                         |     
| |                  |  | $                       | (347
| |                  |  |                         |     
| |                  |  |                         |     
| | Domestic         |  | $                       | (69 
| | Foreign          |  |                         | (278
| |                  |  |                         |     
| |                  |  |                         |     
| |                  |  | $                       | (347
| |                  |  |                         |     

| | 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:

| |                                                      |  | December 31, |       
| | ---------------------------------------------------- |  | ------------ | ------
| |                                                      |  |              |       
| |                                                      |  | 2002         |       
| |                                                      |  |              |       
| | Deferred
  tax assets:                               |  |              |       
| |                                                      |  |              |       
| | Step
  up in FASTs assets (See also Note 15)        |  | $            | 2,454 
| | Reserves
  and allowances                            |  |              | 180   
| | Net
  operating loss carry forwards in subsidiaries  |  |              | 8,252 
| |                                                      |  |              |       
| |                                                      |  |              |       
| | Net
  deferred tax assets before valuation allowance |  |              | 10,886
| | Valuation
  allowance                                |  |              | (9,702
| |                                                      |  |              |       
| |                                                      |  |              |       
| | Net
  deferred tax assets                            |  | $            | 1,184 
| |                                                      |  |              |       
| |                                                      |  |              |       
| | Domestic                                             |  | $            | 271   
| | Foreign                                              |  |              | 913   
| |                                                      |  |              |       
| |                                                      |  |              |       
| |                                                      |  | $            | 1,184 
| |                                                      |  |              |       

| |  | 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.    

- 28 -

---

---

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

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

| |                                                                                                      |  | Year ended December 31, |        
| | ---------------------------------------------------------------------------------------------------- |  | ----------------------- | -------
| |                                                                                                      |  |                         |        
| |                                                                                                      |  | 2001                    |        
| |                                                                                                      |  |                         |        
| |                                                                                                      |  |                         |        
| | Income
  (loss) before taxes, as reported in the
     consolidated statements of operations          |  | $                       | (14,094
| |                                                                                                      |  |                         |        
| |                                                                                                      |  |                         |        
| | Statutory
  tax rate                                                                                 |  |                         | 36     
| |                                                                                                      |  |                         |        
| |                                                                                                      |  |                         |        
| | Theoretical
  tax expense (benefit) on the above
     amount at the Israeli statutory tax rate       |  | $                       | (5,074 
| | Decrease
  in taxes resulting from Approved
     Enterprise benefits (1)                           |  |                         | (532   
| | Tax
  adjustments in respect of inflation in Israel                                                  |  |                         | 346    
| | Tax
  adjustment in respect of foreign subsidiary
     different tax rate                            |  |                         | 52     
| | Deferred
  taxes on losses for which valuation
     allowance was provided                           |  |                         | 4,630  
| | Utilization
  of losses for which valuation
     allowance was provided in prior year                |  |                         | -      
| | Non-deductible
  expenses                                                                            |  |                         | 72     
| | Other                                                                                                |  |                         | 159    
| |                                                                                                      |  |                         |        
| |                                                                                                      |  |                         |        
| | Actual
  tax expense (benefit)                                                                       |  | $                       | (347   
| |                                                                                                      |  |                         |        
| |                                                                                                      |  |                         |        
| | (1)     Per
  share amounts (basic) of the tax
               benefit
  resulting from the exemption |  | $                       | (0.05  
| |                                                                                                      |  |                         |        
| |                                                                                                      |  |                         |        
| | Per
  share amounts (diluted) of the tax
               benefit
  resulting from the exemption       |  | $                       | (0.05  
| |                                                                                                      |  |                         |        

- 29 -

---

---

|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.                  
|          |                     
|          | b.                  
|          |                     
|          | c.                  
|          |                     
|          |                     
|          |                     
|          | d.                  
|          |                     
|          |                     
|          |                     
|          |                     

- 30 -

---

---

|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.)
|--------- | ----------------------------
|          |                             
|          |                             

| |                                                   |  | 2001                |           | 2002                                  |  | 2003                |     
| | ------------------------------------------------- |  | ------------------- | --------- | ------------------------------------- |  | ------------------- | ----
| |                                                   |  |                     |           |                                       |  |                     |     
| |                                                   |  | Amount
  of options |           | Weighted
  average
  exercise
  price |  | Amount
  of options |     
| |                                                   |  |                     |           |                                       |  |                     |     
| | Outstanding - beginning
       of the year        |  |                     | 1,224,116 |                                       |  | $                   | 5.98
| | Granted                                           |  |                     | 717,050   |                                       |  | $                   | 2.77
| | Exercised                                         |  |                     | -         |                                       |  | $                   | -   
| | Forfeited                                         |  |                     | (307,666  | )                                     |  | $                   | 6.46
| |                                                   |  |                     |           |                                       |  |                     |     
| |                                                   |  |                     |           |                                       |  |                     |     
| | Outstanding - end of the
       year              |  |                     | 1,633,500 |                                       |  | $                   | 4.48
| |                                                   |  |                     |           |                                       |  |                     |     
| |                                                   |  |                     |           |                                       |  |                     |     
| | Options exercisable at
       the end of the year |  |                     | 422,500   |                                       |  | $                   | 7.32
| |                                                   |  |                     |           |                                       |  |                     |     

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

| |                                         |  | Weighted average fair value ofoptions granted at an exercise price |     
| | --------------------------------------- |  | ------------------------------------------------------------------ | ----
| |                                         |  |                                                                    |     
| |                                         |  | 2001                                                               |     
| |                                         |  |                                                                    |     
| |                                         |  |                                                                    |     
| | Equals fair
  value at date of grant    |  | $                                                                  | 0.68
| |                                         |  |                                                                    |     
| | Less than
  fair value at date of grant |  | $                                                                  | -   
| |                                         |  |                                                                    |     

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

| |  | Range of
  exercise
  price |           | Options
  outstanding
  as of
  December 31,
  2003 |  | Weighted
  average
  remaining
  contractual
  life (years) |  | Weighted
  average
  exercise
  price |  | Options
  exercisable
  as of
  December 31,
  2003 |  | Weighted
  average
  exercise
  price of
  options
  exercisable |  
| |  | --------------------------- | --------- | --------------------------------------------------- |  | ----------------------------------------------------------- |  | ------------------------------------- |  | --------------------------------------------------- |  | ---------------------------------------------------------------- | -
| |  |                             |           |                                                     |  |                                                             |  |                                       |  |                                                     |  |                                                                  |  
| |  |                             |           |                                                     |  |                                                             |  |                                       |  |                                                     |  |                                                                  |  
| |  | $                           | 1.20-2.67 |                                                     |  | 955,908                                                     |  |                                       |  | 9                                                   |  |                                                                  | $
| |  | $                           | 3.50-4.80 |                                                     |  | 633,937                                                     |  |                                       |  | 4                                                   |  |                                                                  | $
| |  | $                           | 7.50-8.52 |                                                     |  | 348,350                                                     |  |                                       |  | 7                                                   |  |                                                                  | $
| |  |                             |           |                                                     |  |                                                             |  |                                       |  |                                                     |  |                                                                  |  
| |  |                             |           |                                                     |  |                                                             |  |                                       |  |                                                     |  |                                                                  |  
| |  |                             |           |                                                     |  | 1,938,195                                                   |  |                                       |  |                                                     |  |                                                                  | $
| |  |                             |           |                                                     |  |                                                             |  |                                       |  |                                                     |  |                                                                  |  

| | 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.

- 31 -

---

---

|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.           

- 32 -

---

---

|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:

| |                                                         |  | Year ended December 31, |       
| | ------------------------------------------------------- |  | ----------------------- | ------
| |                                                         |  |                         |       
| |                                                         |  | 2001                    |       
| |                                                         |  |                         |       
| |                                                         |  |                         |       
| | Revenues
  from sales to unaffiliated
       customers: |  |                         |       
| | Israel                                                  |  | $                       | 2,428 
| | Germany                                                 |  |                         | 9,725 
| | United
  States                                         |  |                         | 15,091
| | Europe
  (excluding Germany)                            |  |                         | 12,531
| | South
  East Asia                                       |  |                         | 5,753 
| | Others                                                  |  |                         | 1,085 
| |                                                         |  |                         |       
| |                                                         |  |                         |       
| |                                                         |  | $                       | 46,613
| |                                                         |  |                         |       
| |                                                         |  |                         |       
| | Long-lived
  assets:                                    |  |                         |       
| | Israel                                                  |  | $                       | 7,893 
| | Germany                                                 |  |                         | 366   
| | United
  States                                         |  |                         | 3,459 
| | Europe
  (excluding Germany)                            |  |                         | 890   
| | South
  East Asia                                       |  |                         | 187   
| |                                                         |  |                         |       
| |                                                         |  |                         |       
| |                                                         |  | $                       | 12,795
| |                                                         |  |                         |       

- 33 -

---

---

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

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

| |                                                                        |                                             | Year ended December 31, |       
| | ---------------------------------------------------------------------- | ------------------------------------------- | ----------------------- | ------
| |                                                                        |                                             |                         |       
| |                                                                        |                                             | 2001                    |       
| |                                                                        |                                             |                         |       
| |                                                                        |                                             |                         |       
| | Financial
  expenses:                                                  |                                             |                         |       
| |                                                                        |                                             |                         |       
| | Impairment
  of available-for-sale
            marketable
  securities |                                             | $                       | (1,004
| | Foreign
  currency translation differences                             |                                             |                         | (212  
| | Other                                                                  |                                             |                         | (140  
| |                                                                        |                                             |                         |       
| |                                                                        |                                             |                         |       
| |                                                                        |                                             |                         | (1,356
| |                                                                        |                                             |                         |       
| | Financial
  income:                                                    |                                             |                         |       
| |                                                                        |                                             |                         |       
| | Income
  from interest on marketable
            securities            |                                             |                         | 384   
| | Interest                                                               |                                             |                         | 562   
| | Foreign
  currency translation differences                             |                                             |                         | -     
| | Other                                                                  |                                             |                         | -     
| |                                                                        |                                             |                         |       
| |                                                                        |                                             |                         |       
| |                                                                        |                                             |                         | 946   
| |                                                                        |                                             |                         |       
| |                                                                        |                                             |                         |       
| |                                                                        |                                             | $                       | (410  
| |                                                                        |                                             |                         |       
| |                                                                        |                                             |                         |       
| | b.                                                                     | Other
  expenses, net:                      |                         |       
| |                                                                        |                                             |                         |       
| |                                                                        | Impairment
  of investment in other company |                         | $     
| | Impairment
  of investment in FAST                                     |                                             |                         | (3,350
| | Other,
  net                                                           |                                             |                         | (22   
| |                                                                        |                                             |                         |       
| |                                                                        |                                             |                         |       
| |                                                                        |                                             | $                       | (3,372
| |                                                                        |                                             |                         |       

- 34 -

---

---

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

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

| |                                                                                                                                                                  |  | Year ended December 31, |        
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | -------
| |                                                                                                                                                                  |  |                         |        
| |                                                                                                                                                                  |  | 2001                    |        
| |                                                                                                                                                                  |  |                         |        
| | 1.
  Numerator:                                                                                                                                                  |  |                         |        
| |                                                                                                                                                                  |  |                         |        
| | Net
  income (loss) to shareholders of
            Ordinary shares                                                                                               |  | $                       | (14,915
| |                                                                                                                                                                  |  |                         |        
| |                                                                                                                                                                  |  |                         |        
| | Numerator
  for basic and diluted net
            earnings (loss) per share -
  income
            (loss) available to Ordinary
            shareholders         |  | $                       | (14,915
| |                                                                                                                                                                  |  |                         |        
| |                                                                                                                                                                  |  |                         |        
| | 2.
  Denominator:                                                                                                                                                |  |                         |        
| |                                                                                                                                                                  |  |                         |        
| | Weighted
  average number of shares                                                                                                                              |  |                         | 11,466 
| | Weighted
  average number of treasury
            shares                                                                                                         |  |                         | (191   
| |                                                                                                                                                                  |  |                         |        
| |                                                                                                                                                                  |  |                         |        
| | Denominator
  for basic net earnings
             (loss) per share                                                                                               |  |                         | 11,275 
| |                                                                                                                                                                  |  |                         |        
| |                                                                                                                                                                  |  |                         |        
| | Effect
  of dilutive securities:                                                                                                                                 |  |                         |        
| | Employee
  stock options                                                                                                                                         |  |                         | *)   - 
| |                                                                                                                                                                  |  |                         |        
| |                                                                                                                                                                  |  |                         |        
| | Dilutive
  potential Ordinary shares                                                                                                                             |  |                         | *)   - 
| |                                                                                                                                                                  |  |                         |        
| |                                                                                                                                                                  |  |                         |        
| | Denominator
  for diluted net earnings
             (loss) per share - adjusted
  weighted
            average shares, assumed
  exercise of
            options |  |                         | 11,275 
| |                                                                                                                                                                  |  |                         |        
| |                                                                                                                                                                  |  |                         |        
| | *)     Antidilutive.                                                                                                                                             |  |                         |        

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

- 35 -



---

---

# REPORT OF INDEPENDENT
AUDITORS

# To the shareholders of

# ALADDIN WESTERN EUROPE
LIMITED

We have audited the accompanying
balance sheets of Aladdin Western Europe Limited (the Company), as of December
31, 2002 and 2003, and the related statements of operations and changes in
shareholders equity 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
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
statements 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 for each of the three years in the period ended December 31, 2003, in
conformity with U.S. generally accepted accounting principles.

|                                                                          |                                          
|------------------------------------------------------------------------- | -----------------------------------------
|BLICK ROTHENBERG
Chartered Accountants
Registered Auditors 
29 March 2004 | 12 York Gate
Regent's Park
London
NW1 4QS

---

---