# SECURITIES
  AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

_________________

# FORM 20-F

|                                                                                                                                          | **REGISTRATION
        STATEMENT PURSUANT TO SECTION 12(b) OR (g) 
        OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                      
|----------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                          | **OR**                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                          | **ANNUAL
        REPORT PURSUANT TO SECTION 13 OR 15(d) 
        OF THE SECURITIES EXCHANGE ACT OF 1934
        FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004**                                                                                                                                                                                                                                                            
|                                                                                                                                          | **OR**                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                          | **TRANSITION
        REPORT PURSUANT TO SECTION 13 OR 15(d) 
        OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                            
|                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                          | Commission
        File No. 1-8201                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                          | _________________                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                          | **ALADDIN
        KNOWLEDGE SYSTEMS LTD.**                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                          | (Exact
            name of Registrant as specified in its charter and translation of
            Registrants name into English)                                                                                                                                                                                                                                                                                         
|                                                                                                                                          | _________________                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                          | **Israel**
        (Jurisdiction of incorporation or organization) **15 Beit Oved Street, Tel Aviv 61110, Israel**
        (Address of principal executive offices) _________________                                                                                                                                                                                                                                    
|                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                          | Securities
        registered or to be registered pursuant to Section 12(b) of the Act:None**Securities registered or to be registered pursuant to Section
        12(g) of the Act:**
        Ordinary Shares, nominal value 0.01 New Israeli Shekel per share
        (Title of Class) Securities for which there is a reporting obligation pursuant to Section
        15(d) of the Act:None 
        (Title of Class)
|                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                          
|Indicate
      the number of outstanding shares of each of the issuers classes of
      capital or common stock as of December 31, 2004:
|                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                          | 12,345,536
        Ordinary Shares
        _________________                                                                                                                                                                                                                                                                                                                                                             

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

| | Yes | No
| | --- | --

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

| | Item 17 | Item 18
| | ------- | -------

---

CAUTIONARY NOTE FOR
FORWARD-LOOKING STATEMENTS


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


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


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



expectations
as to the development of our products and technology, and the timing of enhancements to
our products and new          product launches;
statements as to expected increases in sales, results of operations and certain expenses,
including research and development and sales and marketing expenses;
    expectations as
      to the market opportunities for our products, as well as our ability to
      take advantage of those opportunities;
statements
as to the expected use of proceeds from this offering;
expectations
as to growth of the software DRM and enterprise security markets;
expectations
as to the development of our marketing and sales relationships;
statements
as to the expected outcome of legal and patent proceedings in which we are involved;
estimates
of the impact of changes in currency exchange rates on our results of operations;
expectations
as to the adequacy of our inventory of critical components;
expectations
as to the adequacy of our manufacturing facilities; and
statements
as to our expected treatment under Israeli and U.S. federal tax legislation and the
impact that Israeli tax and          corporate legislation may have on our operations.As
used in this annual report, the terms we, us, our, the
Company and Aladdin mean Aladdin Knowledge Systems Ltd. and its
subsidiaries, unless otherwise indicated.


We
  have prepared our consolidated financial statements in United States dollars
  and in accordance with accounting principles generally accepted in the United
  States.  All references herein to dollars or $
  are to United States dollars, and all references to Shekels or NIS
  are to New Israeli Shekels.
-2-


TABLE OF CONTENTS


PART I
  1Item 1.          Identity of Directors, Senior Management and Advisers
     1Item 2.          Offer Statistics and Expected Timetable
     1Item 3.          Key Information
     1A. SELECTED FINANCIAL DATA
     1B. CAPITALIZATION AND INDEBTEDNESS
     2C. REASONS FOR THE OFFER AND USE OF PROCEEDS
     2D. RISK FACTORS
     3Item
     4.          Information on the Company
     11A. HISTORY AND DEVELOPMENT OF THE COMPANY
     11B. BUSINESS OVERVIEW
     11C. ORGANIZATIONAL STRUCTURE
     21D. PROPERTY, PLANTS AND EQUIPMENT
     21Item
           5.          Operating
     and Financial Review and Prospects
     21CRITICAL ACCOUNTING POLICIES AND ESTIMATES
     24RESULTS OF OPERATIONS
     26LIQUIDITY
     AND CAPITAL RESOURCES
     30INVESTMENTS
     31CORPORATE
     TAX
     32Item 6.          Directors,
     Senior Management and Employees
     32A. DIRECTORS AND SENIOR MANAGEMENT
     32B. COMPENSATION
     35C. BOARD PRACTICES
     36D.
     EMPLOYEES
     38E. SHARE OWNERSHIP
     38Item
           7.          Major
     Shareholders and Related Party Transactions
     38A.
     MAJOR SHAREHOLDERS
     38B. RELATED PARTY TRANSACTIONS
     39C.
     INTERESTS OF EXPERTS AND COUNSEL
     40Item 8.          Financial
     Information
     40A.     CONSOLIDATED
     STATEMENTS AND OTHER FINANCIAL INFORMATION
     40B.     SIGNIFICANT
     CHANGES
     40Item 9.          The
     Offer and Listing
     40A.     OFFER
     AND LISTING DETAILS
     40B.     PLAN
     OF DISTRIBUTION
     42C.     MARKETS
     42D.     SELLING SHAREHOLDERS
     42E.     DILUTION
     42F.     EXPENSES
     OF THE ISSUE
     42Item 10.          Additional
     Information
     42A.     SHARE
     CAPITAL
     42B.     MEMORANDUM
     AND ARTICLES OF ASSOCIATION
     43C.     MATERIAL
     CONTRACTS
     46D.     EXCHANGE
     CONTROLS
     46E.     TAXATION
     46F.     DIVIDENDS
     AND PAYING AGENTS
     53G.     STATEMENTS
     BY EXPERTS
     53H.     DOCUMENTS
     ON DISPLAY
     53I.     SUBSIDIARY
     INFORMATION
     53Item 11.          Quantitative
     and Qualitative Disclosures about Market Risk
     53Item 12.          Descriptions
     of Securities Other than Equity Securities
     55PART II
     55Item 13.          Defaults,
     Dividend Arrearages and Delinquencies
     55Item
           14.          Material
     Modifications to the Rights of Security Holders and Use of Proceeds
     55-i-
Item
      15.          Controls
      and Procedures
    55Item
      16A.       Audit
      Committee Financial Expert
    55Item
      16B.       Code
      of Ethics
    55Item
      16C.       Principal
      Accountant Fees and Services
    55Item
      16D.       Exemptions
      for the Listing Standards for Audit Committees
    56Item
      16E.       Purchase
      of Equity Securities by the Issuer and Affiliated Purchasers
    56PART
      III
    56Item
      17.          Financial
      Statements
    56Item
      18.          Financial
      Statements
    56Item
           19.          Exhibits
    56-ii-
PART
  I


Item
  1.          Identity of Directors,
  Senior Management and Advisers


Not Applicable.


Item
  2.          Offer Statistics
  and Expected Timetable


Not Applicable.


Item
  3.         Key Information


A.
  SELECTED FINANCIAL DATA.


We
derived the selected consolidated statement of operations data set forth below for the
years ended December 31, 2002, 2003 and 2004, and the selected consolidated balance sheet
data as of December 31, 2003 and 2004, from our audited consolidated financial statements,
included elsewhere in this annual report. We derived the consolidated statement of
operations data for the years ended December 31, 2000 and 2001 and the selected
consolidated balance sheet data as of December 31, 2000, 2001 and 2002 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. Our consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
(GAAP).


The
following selected financial data should be read in conjunction with the section of this
annual report entitled Operating and Financial Review and Prospects and our
consolidated financial statements and notes thereto included elsewhere in this annual
report. Historical results are not necessarily indicative of any results to be expected in
any future period. Please see notes 2 and 15 of the notes to our audited consolidated
financial statements for an explanation regarding the computation of basic and diluted net
earnings (loss) per ordinary share.

Year
      ended December 31,2000
    2001
    2002
    2003
    2004(In
      thousands, except earnings per share data)**Consolidated statement of income
      data:**Revenues:Software
      security
    
    
    $
    38,134
    
    $
    38,421
    
    $
    40,093
    
    $
    43,521
    
    $
    50,650Enterprise
      security
    
    
    
    6,211
    
    
    8,192
    
    
    9,427
    
    
    11,204
    
    
    18,471Total revenues
    
    
    
    44,345
    
    
    46,613
    
    
    49,520
    
    
    54,725
    
    
    69,121Cost of revenues:Software
      security
    
    
    
    9,650
    
    
    7,753
    
    
    8,054
    
    
    7,995
    
    
    9,541Enterprise
      security
    
    
    
    995
    
    
    1,567
    
    
    1,833
    
    
    1,804
    
    
    4,240Total cost of revenues
    
    
    
    10,645
    
    
    9,320
    
    
    10,238
    
    
    9,799
    
    
    13,781Gross profit
    
    
    
    33,700
    
    
    37,293
    
    
    39,282
    
    
    44,926
    
    
    55,340Operating expenses:Research
      and development
    
    
    
    9,792
    
    
    11,043
    
    
    12,245
    
    
    12,759
    
    
    12,028Selling
      and marketing
    
    
    
    20,752
    
    
    22,474
    
    
    21,990
    
    
    22,012
    
    
    24,677General
      and administrative
    
    
    
    6,657
    
    
    8,877
    
    
    7,247
    
    
    7,745
    
    
    8,805Impairment
      of intangibles assets
    
    
    
    
    
    
    5,211
    
    
    
    
    
    
    
    
    Total operating expenses
    
    
    
    37,201
    
    
    47,605
    
    
    41,482
    
    
    42,516
    
    
    45,510Operating income (loss)
    
    
    
    (3,501
    )
    
    (10,312
    )
    
    (2,200
    )
    
    2,410
    
    
    9,830Financial income (expenses), net
    
    
    
    1,421
    
    
    (410
    )
    
    491
    
    
    480
    
    
    53Other income (expenses), net
    
    
    
    5,483
    
    
    (3,372
    )
    
    (932
    )
    
    (5
    )
    
    (138
    )Income (loss) before taxes
    
    
    
    3,403
    
    
    (14,094
    )
    
    (2,641
    )
    
    2,885
    
    
    9,745Taxes on income
    
    
    
    1,640
    
    
    (347
    )
    
    2,738
    
    
    49
    
    
    957Income (loss) before equity in losses of an affiliate
    
    
    
    1,763
    
    
    (13,747
    )
    
    (5,379
    )
    
    2,836
    
    
    8,788Equity in losses of an affiliate
    
    
    
    (323
    )
    
    (1,168
    )
    
    (1,257
    )
    
    (100
    )
    
    Net income (loss)
    
    
    $
    1,440
    
    $
    (14,915
    )
    $
    (6,636
    )
    $
    2,736
    
    $
    8,788Net earnings (loss) per share:Basic
    
    
    $
    0.13
    
    
    (1.32
    )
    $
    (0.59
    )
    $
    0.24
    
    $
    0.74Diluted
    
    
    $
    0.12
    
    
    (1.32
    )
    $
    (0.59
    )
    $
    0.23
    
    $
    0.68Weighted average number of shares used incomputing net earnings (loss) per share:Basic
    
    
    
    11,424
    
    $
    11,275
    
    
    11,253
    
    
    11,287
    
    
    11,940Diluted
    
    
    
    11,743
    
    $
    11,275
    
    
    11,253
    
    
    11,950
    
    
    13,000December 31,2000
     2001
     2002
     2003
     2004Consolidated balance sheet data:
     (In thousands)Cash, cash
      equivalents and marketable securities
    
    

    $
    28,519

    

    $
    13,438

    

    $
    15,095

    

    $
    19,516

    

    $
    25,911Working capital
     34,519
        
     24,649
        
     22,664
        
     26,625
        
     34,326Total assets
    
    

    
    73,030

    

    
    53,395

    

    
    48,539

    

    
    55,468

    

    
    70,894Total liabilities
     14,334
        
     10,765
        
     12,212
        
     14,512
        
     17,457Shareholders
      equity
    
    

    
    58,696

    

    
    42,630

    

    
    36,327

    

    
    40,956

    

    
    53,437B.
  CAPITALIZATION AND INDEBTEDNESS


Not applicable.


C.
  REASONS FOR THE OFFER AND USE OF PROCEEDS


Not applicable.


-2-
D.
  RISK FACTORS


RISKS RELATED TO OUR
BUSINESS


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


We face intense competition
  in each of the segments in which we operate. In the hardware-based software
  licensing authentication token, or SLAT, market, our software digital rights
  management, or DRM, solutions compete with products sold by SafeNet Inc. (which
  recently acquired Rainbow Technologies Inc.) and in the software-based software
  protection market, our primary competitor is Macrovision Corporation. Our principal
  competitor in the authentication market is RSA Security Inc., which holds a
  dominant position in the one-time passwords (OTP) market, and SafeNet, which
  manufactures a USB-based authentication product. We also compete with smart
  card manufacturers. Our primary competitor in the content security market for
  gateway solutions is Trend Micro Inc., which holds a dominant market position.
  In addition, the overall content security market is characterized by a number
  of large companies, such as Symantec Corporation, McAfee, Inc. and Trend Micro,
  which in 2003 together accounted for over 60% of global revenues in this market,
  as well as a large number of small companies. While the products sold by these
  companies primarily address desktop or network solutions and not the gateway
  solution eSafe addresses, we would face significant additional competition if
  these companies decided to develop and market gateway solutions. In addition,
  vendors of firewalls might decide to extend their offerings to gateway security
  and these could compete with our eSafe product. Many of our current and potential
  competitors have significantly greater name recognition, larger customer bases
  and greater financial, technical, manufacturing, marketing and other resources
  than we do. Our results of operations will be adversely affected if our competitors
  succeed in marketing products with superior performance or at lower prices than
  our products.


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


We deliver our products promptly
  following the receipt of customer orders and, therefore, we do not have a significant
  backlog. In addition, a large proportion of our sales is concentrated at the
  end of each quarter. These factors make it difficult to project our quarterly
  results of operations. Commencing in the first quarter of 2004, and for each
  quarter thereafter, we have released financial guidance to the public during
  the first month of each quarter with respect to that quarter. Should our actual
  results of operations fall short of our guidance or analysts estimates,
  the price of our ordinary shares may decline.


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


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


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


We purchase certain key components
  for each of our hardware-based products from sole source suppliers. In particular,
  we obtain from sole source suppliers the application specific integrated circuits
  and microcontrollers included in our HASP products, and the microcontroller
  and the smart card, including its operating system, for our eToken products.
  In addition, we license the anti-spam and web filtering functions incorporated
  in eSafe and receive services related to these functions from a third party
  pursuant to a license agreement that expires in June 2005. We
-3-

would need to seek an alternative
  licensor and service provider for these functions if this third party ceases
  to provide these services or decides not to renew the license. If any of our
  suppliers become unable to or refuses to manufacture these components or if
  we experience delays in delivery of, or shortages in, these components, it could
  interrupt and delay the manufacture of our products. In the event of a disruption
  in supply, we cannot assure you that our inventory would be sufficient to enable
  us to continue manufacturing during the time that it would take to modify the
  design and integrate substitute components. Any such disruption could adversely
  affect our results of operations.


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


We cannot assure you that
  software publishers will continue to prefer to protect their software through
  hardware-based solutions over software-based solutions. A change in preference
  towards software-based solutions could materially adversely affect the sales
  of our HASP HL token-based products, which currently represent over 70% of our
  total revenues. In addition, even if our software-based HASP SL solution was
  adopted by software publishers, this would have a material adverse affect on
  our results of operations.


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


Software developers have
  started to add security features to new versions of their software that are
  designed to limit intrusions by unauthorized users or viruses and 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 such as
  eSafe. As the incorporation of such features in future versions of operating
  systems and software make these systems less susceptible to outside penetration,
  our eSafe product may be rendered obsolete or unmarketable.


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


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


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


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

-4-
We may not be able to
  prevent others from successfully claiming that we infringed their proprietary
  rights.


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


In the past, we have been
    subject to claims that resulted in us paying amounts in settlements or obtaining
    licenses to use intellectual property rights as a result of third-party claims
    against us. In May 2004, we were named as defendant in a U.S. patent infringement
    complaint alleging that certain of our products infringed a now-expired patent.
    In April 2005, we reached a settlement with respect to this claim pursuant
    to which we made a one-time payment of $2 million to the plaintiffs in exchange
    for a full release of all claims. In addition, from time to time,
  we have received notices from third parties offering to license to us certain
    aspects of their technology. Any infringement or other intellectual property
    claims, with or without merit, which are brought against us could be time
    consuming
  and expensive to litigate or settle and could divert managements attention
   from our business.


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


Our success and ability to
  compete greatly depends on our proprietary technology. We rely on a combination
  of patents, copyrights, trademarks, trade secrets, know-how and confidentiality
  clauses in our agreements to protect our intellectual property. We cannot assure
  you that we will successfully protect our technology because:



to license our products, we rely on shrink wrap licenses that are not signed
by the customer and, therefore, we may not be able to enforce our proprietary rights under
the laws of certain jurisdictions;
some
foreign countries may not protect our proprietary rights as fully as the laws of the
United States;
if a competitor were to infringe our proprietary rights, enforcing our rights may be
time-consuming and costly, diverting both our managements attention and our
resources, and could result in challenges to the validity of our rights;
measures such as entering into non-disclosure agreements afford only limited protection
because monitoring unauthorized uses of trade secrets and confidential information is
difficult and we may not have adequate remedies for any breach of our agreements;
unauthorized
parties may attempt to copy aspects of our products and develop similar software or to
obtain and use          information that we regard as proprietary; and
our competitors may be able to independently develop products that are substantially
equivalent or superior to our products or design around our intellectual property rights.We also have a number of
  patent applications pending. We cannot be certain that patents will be issued
  with respect to any of our pending or future patent applications or, that if
  patents are issued, the patents will be issued in a form that is advantageous
  to us. Of the several patent applications that we have filed directed towards
  our NitroInspection technology in on-line web content security one U.S. and
  one European patent application have been rejected. We are currently appealing
  the rejection of the U.S. application. In the event that these or any other
  patent applications are published but not issued, they will become publicly
  available and proprietary information will become available to others. In addition,
  we do not know whether any issued patents will be upheld as valid, proven enforceable
  against alleged infringers or that they will prevent the development of competitive
  products.


-5-
Sales of products that
  contain encryption technologies are subject to export and other restrictions,
  and our failure to comply with applicable government regulations could subject
  us to sanctions and adversely affect our ability to sell our products.


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


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


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


We market and sell our software
  DRM products through independent distributors in all of the countries in which
  we do not have subsidiaries, and we market and sell our eSafe and eToken product
  lines generally through indirect sales channels, which include independent distributors.
  In 2004, 38.6% of our revenues were generated from sales to independent distributors.
  Under our agreements with independent distributors, each distributor is granted
  a non-exclusive right in each particular country or region to market our products
  for an initial term of one year, subject to meeting minimum sales targets. Our
  success in generating sales in countries or regions where we have engaged independent
  distributors depends in part on their efforts. We cannot assure you that our
  distributors will devote sufficient resources to market and support our products
  effectively or that they will meet minimum sales targets. In the future, we
  intend to sign additional distribution agreements, which may make us more dependent
  on our distributors. In addition, if we decide to terminate a relationship with
  an independent distributor, this could disrupt our relationships with customers
  served by the terminated distributor.


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


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


-6-
Fluctuations in currency
  exchange rates may have a significant impact on our reported results of operations.


Although our reporting currency
  is the U.S. dollar, a significant portion of our revenues and expenses are denominated
  in currencies other than the U.S. dollar including, in particular, the Euro.
  In periods when the U.S. dollar strengthens against these other currencies our
  reported results of operations may be adversely affected. Recently, the U.S.
  dollar has weakened substantially against the Euro, the Japanese Yen and the
  British pound, which has positively affected our results of operations. In addition,
  fluctuations in currencies may result in valuation adjustments in our assets
  and liabilities which could affect our reported results of operations.


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


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


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


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


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


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


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


Our software DRM products
  do not provide absolute protection against piracy. We, together with our customers,
  continuously face challenges from computer hackers, who attempt to neutralize
  the protection our products provide in order to enable unlicensed copying of
  our customers software. In recent years, we have faced increasing attacks
  by hackers who have developed methods to circumvent the protection provided
  by our software DRM products. Such methods are often publicized over the Internet,
  making them readily available to those who wish to make unlicensed copies of
  our customers software. We are constantly in the process of developing
  and releasing solutions designed to respond to our customers complaints
  and handle hacking problems. Furthermore, we have recently received notifications
  from some of our customers informing us that hackers had succeeded in breaking
  the protection provided by our HASP products. 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.


-7-
Our content security products
  may fail to protect our customers networks from virus attacks and vandalism,
  which could seriously harm our business.


Our content security products
  do not provide absolute protection against viruses and vandalism. We, together
  with our customers, continuously face challenges from hackers, who attempt to
  neutralize the protection 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 hold investments in
  funds that are managed by third parties, as well as minority investments, and
  may be required to realize impairment charges with respect to these investments.


We currently hold investments,
  which were valued at $6.3 million as of December 31, 2004, in two related
  investment funds managed by Tamir Fishman Ventures Management II Ltd. We do
  not exercise any control over the operating and financial policies of these
  funds and, in 2002, we recorded an impairment charge of $1.0 million related
  to these investments. In addition, we have invested $1,050,000 in Idesia Ltd.
  (formerly known as C-Signature Ltd.), an Israeli company engaged in biometric
  identity recognition technology, and we hold investments in two companies that
  trade on the Tel Aviv Stock Exchange with a fair market value of $1.6 million
  as of December 31, 2004. We may be required to recognize further impairment
  charges related to all or a portion of our investments, which would reduce our
  net income and may adversely affect our share price.


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


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



diversion of our managements time after consummation of the acquisition from the
ongoing development of our businesses, and the release of future products and services;
a decline in employee morale and retention issues, both at our company and at the acquired
company, resulting from changes in compensation, reporting relationships, future prospects
or the direction of the business; and
integration
of new product lines, accounting, management and internal controls.Future acquisitions could
  also result in potentially dilutive issuances of equity securities, the incurrence
  of debt, contingent liabilities or impairment related to goodwill and other
  intangible assets, any of which could harm our business. In addition, future
  acquisitions could require us to obtain additional equity or debt financing,
  which may not be available on favorable terms or at all and may be dilutive.


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


Our activities in Europe
  require that we comply with European Union Directives with respect to product
  quality assurance standards and environmental standards. Directive 2002/95/ec
  of the European Parliament on the Restriction of the Use of Certain Hazardous
  Substances in Electrical and Electronic Equipment, known as the RoHS Directive,
  will take effect on July 1, 2006 and requires that certain of our products
  be modified to meet this regulation. Some of our distributors and customers
  are already requiring us to comply with these new rules so as not to be left
  with noncompliant inventory when the RoHS Directive takes effect. If we fail
  to achieve compliance, we may be restricted from selling our products in the
  European Union and this could adversely affect our results of operations.


RISKS RELATED TO OUR
ORDINARY SHARES


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


Our
  ordinary shares have been subject to and will continue to be subject to a great
  deal of volatility. For example, during 2004, the price of our ordinary shares
  on The Nasdaq National Market fluctuated between $8.73 and $32.12
-8-
per share. We cannot predict
  the fluctuations in the market price of our ordinary shares. The broader market
  for technology stocks and, in particular, those of companies based in Israel
  has also been subject to significant price fluctuations. These broad market
  fluctuations may adversely affect the market price of our ordinary shares, regardless
  of our actual operating performance. Such volatility in relation to our ordinary
  shares may also affect our ability to raise additional equity financing in the
  future.


Our
Chairman and Chief Executive Officer, Jacob (Yanki) Margalit, and our director and
Executive Vice President, Technologies, Dany Margalit, have significant influence over
matters requiring shareholder and board approval.


Our Chairman and Chief Executive
  Officer, Jacob (Yanki) Margalit, and our director and Executive Vice President,
  Technologies, Dany Margalit, collectively own or control 18.8% of our outstanding
  ordinary shares. Messrs. Margalit are brothers, and both sit on our board of
  directors which comprises a total of five members. Accordingly, they have substantial
  influence over the outcome of corporate actions requiring director or shareholder
  approval, including the election of directors, any merger, consolidation or
  sale of all or substantially all of our assets and any other significant corporate
  transaction. These shareholders may also delay or prevent a change of control
  of us, even if such a change of control would benefit our other shareholders.


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


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


RISKS RELATED TO OUR
OPERATIONS IN ISRAEL


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


Our
corporate headquarters, our manufacturing facilities and our principal research and
development facilities are located in Israel. Accordingly, security, political and
economic conditions in Israel directly affect our business. Over the past several decades,
a number of armed conflicts have taken place between Israel and its Arab neighbors. Since
2000, hostilities have increased in intensity, and regional political uncertainty has also
increased. Continued or increased hostilities, future armed conflicts, political
developments in other states in the region, or continued or increased terrorism could make
it more difficult for us to conduct our operations in Israel, which could increase our
costs and adversely affect our financial results. For example, any major escalation in
hostilities in the region could result in a portion of our employees being called up to
perform military duty for an extended period of time.


Israel
has recently experienced 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 would affect our ability to deliver our products to our non-Israeli customers. We
cannot guarantee that a prolonged general strike in Israel would not have a material
adverse effect on our business, results of operations and financial condition.


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


Three of our expansion programs
  in Israel have been granted approved enterprise status and a fourth program
  is in the process of implementation prior to obtaining final approval. We are
  therefore eligible for tax benefits under the Israeli Law for Encouragement
  of Capital Investments, 1959. The availability of these tax benefits is subject
  to certain requirements, including making specified investments in property
  and equipment, and financing a percentage
-9-
of investments with share
  capital. If we do not meet these requirements in the future, the tax benefits
  may be canceled and we could be required to refund any tax benefits that we
  have already received, plus interest and penalties thereon. We cannot assure
  you that the tax benefits that our current approved enterprise programs receive
  will be continued in the future at their current levels or at all. If these
  tax benefits were reduced or eliminated, the amount of taxes that we pay would
  likely increase. See Item 10 Additional Information  Section
  E.Israeli Taxation.


Certain
documents that we have signed after June 1, 2003 might be subject to Israeli stamp tax
duty.


Pursuant
to an amendment to the Stamp Tax on Documents Law, 1961, the Israeli tax authorities have
commenced enforcement of the provisions of the Stamp Tax Law. In connection therewith, we
have received a demand from the Israeli tax authorities to provide them with all documents
dated after June 1, 2003 that are subject to stamp tax pursuant to the Stamp Tax Law.
Similar demands have been made upon numerous companies in Israel. Currently, the High
Court of Justice is considering a petition brought on behalf of an industry group that
requests that the court clarify and narrow the scope of the statutory amendment. As a
result, we may be liable to pay stamp taxes on some or all of the documents we have signed
since June 1, 2003, which may adversely affect our results of operations.


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


We are
incorporated in Israel. The majority of our executive officers and directors are not
residents of the United States, and the majority of our assets and the assets of these
persons are located outside the United States. Therefore, it may be difficult for an
investor, or any other person or entity, to enforce a U.S. court judgment based upon the
civil liability provisions of the U.S. federal securities laws against us or any of these
persons in an Israeli court, or to effect service of process upon these persons in the
United States. Additionally, it may be difficult for an investor, or any other person or
entity, to assert U.S. securities law claims in original actions instituted in Israel.
Israeli courts may refuse to hear a claim based on a violation of U.S. securities laws
because Israel is not the most appropriate forum in which to bring such a claim. In
addition, even if an Israeli court agrees to hear a claim, it may determine that Israeli
law and not U.S. law is applicable to the claim. If U.S. law is found to be applicable,
the content of applicable U.S. law must be proved as a fact which can be a time-consuming
and costly process. Certain matters of procedure will also be governed by Israeli law.
There is little binding case law in Israel addressing the matters described above.


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


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


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


Provisions of Israeli law
  may delay, prevent or make undesirable a merger or an acquisition of all or
  a significant portion of our shares or assets. Israeli corporate law regulates
  acquisitions of shares through tender offers and
-10-
mergers, requires special
  approvals for transactions involving significant shareholders and regulates
  other matters that may be relevant to these types of transactions. These provisions
  of Israeli law could have the effect of delaying or preventing a change in control
  and may make it more difficult for a third party to acquire us, even if doing
  so would be beneficial to our shareholders. These provisions may limit the price
  that investors may be willing to pay in the future for our ordinary shares.
  Furthermore, Israeli tax considerations may make potential transactions undesirable
  to us or to some of our shareholders.


Item 4. Information on
the Company


A. HISTORY AND
DEVELOPMENT OF THE COMPANY


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


Capital Expenditures


During
the past three years, our capital expenditures amounted to approximately $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, our
CRM systems and leasehold improvements in our offices. We continue to make capital
investments of a similar nature in our Israeli facilities and also in connection with our
production activities.


B. BUSINESS OVERVIEW


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


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


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


Within
the software DRM market, we focus on the hardware-based software licensing authentication
token, or SLAT, market, which is the largest segment of the software DRM market. According
to IDC, a market research firm focused on the information technology and
telecommunications industries, in 2003 we were the global leader in the SLAT market with a
35.4% market share. We have grown our customer base through a history of innovation in the
security market and have a broad portfolio of intellectual property, including a number of
patents and patent applications pending.


We have experienced significant
  growth since our founding in 1985. Over the last two years, we have achieved
  growth that is above the industry average in each of our segments and we have
  increased our profitability in each of the last seven quarters. We believe that
  our core strength in the software DRM business is complemented by
-11-
increasing growth in the
  enterprise security segment, which has grown from 19.0% of our total revenues
  in 2002 to 26.7% of our total revenues in 2004.


Industry Background


With
global software piracy, malicious code attacks and unauthorized network access presenting
ever-greater threats, the need for reliable digital security solutions has never been
greater. To combat increasing software piracy, software publishers are seeking DRM
solutions to protect their intellectual property. Software DRM solutions reduce software
piracy by using either hardware- or software-based software protection solutions. To avoid
malicious code attacks and unauthorized network access, and to enhance enterprise
security, organizations are seeking authentication and content security solutions.
Authentication solutions positively identify users (internally as well as from outside the
enterprise) before granting access to critical applications and resources. Content
security solutions protect networks against viruses, worms, spam and other Internet- and
e-mail-borne unwanted content.


***Software
  DRM overview***


The
advancement of digital technologies makes it possible to produce an essentially perfect
copy of any digital asset with minimal effort. Piracy affects all forms of digital
content, such as music, movies, text and software. With the advent of the personal
computer, software piracy first became an issue in the 1980s. Development of the Internet
in the 1990s virtually eliminated the need for a physical medium to perform illegal
transfers of digital assets. According to a July 2004 study by the Business Software
Alliance and IDC, software developers lost $29 billion of potential revenue in 2003 due to
software piracy, and in some countries more than 90% of all software in use is pirated.


Software
piracy impacts software publishers by preventing them from realizing all of the licensing
revenue from the use of their software products. Software piracy can occur in many forms,
including end-users making unauthorized copies and distributing them to friends or
co-workers, retailers selling illegal copies, computer dealers loading illegal copies onto
their customers hardware, commercial counterfeiters offering illegal copies for sale
and enterprises exceeding the number of users or scope of use authorized by license
agreements.


Software
DRM can be implemented either through a hardware device or a software solution. The
hardware device is a hardware key that connects either to the USB or parallel
port of a computer and unlocks software residing on that computer. IDC refers
to this market as the software licensing authentication token, or SLAT, market and
projects that this market will grow from $118 million in 2003 to $161 million in 2008.
Software-based solutions allow software publishers to control end-use without distributing
a hardware device and may also include licensing and distribution capabilities.


Software DRM market
trends


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



Growth of piracy on the Internet. Increasing broadband access combined with peer-to-peer
(P2P) networks and Internet publishing tools, such as bulletin boards and weblogs, are
facilitating a rise in software piracy which can be limited by adopting software DRM
solutions.
Increasing variety of software licensing models.License management is an increasing
concern for software publishers. Software license models are evolving and software
publishers now deliver their software in an increasing variety of schemes including
try-before-you-buy, pay-as-you-go or
use-for-a-limited-period. These more flexible licensing options drive the need
for new software DRM solutions.
Electronic software distribution.Software distribution is at the early stages of moving
away from the traditional shrink-wrapped box towards electronic software distribution, or
ESD. As ESD gains popularity and transmission of software becomes easier, software will
become more vulnerable to piracy, on a wider scale, increasing the need for anti-piracy
technologies.
Adoption of DRM features by platform vendors.In recent years, Microsoft has been
implementing an increasing number of DRM features into its operating systems. This
development has led to DRM solutions becoming more widely accepted by software publishers.-12-
***Enterprise
  security overview***


Enterprise
security has become a critical element of enterprise networks due to the high costs
associated with network security breaches, corruption of software environments and legal
exposure. To combat these effects, organizations are primarily focused on securing their
networks by controlling who accesses their networks (authentication) and what content
users can utilize (content security).


***Authentication
  overview***


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


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


***Authentication
  market trends***


According
to IDC, the traditional OTP token market is projected to grow from $177 million in 2003 to
$240 million in 2008, representing a compound annual growth rate of 6%. The USB hardware
authentication market is projected to grow from $23 million to $206 million during this
same period, representing a compound annual growth rate of 55%. We believe that the
following are key growth drivers of the authentication market:



Increasing access to enterprise networks.The need for authentication credentials is
increasing, as the scope of access to enterprise networks expands. Enterprises are
expanding access to their networks to mobile workers and telecommuters, as well as to
customers and business partners. Enterprises are also allocating more resources to
authentication solutions for internal access.
Realization of password management costs.While stand-alone passwords as an authentication
method were once viewed as free, according to a May 2004 report entitled,
Fortifying the Password Reset Process by Forrester Research, Inc., a
technology market research firm, the most common call to help desks and support centers
relates to passwords, costing a company $10 or more per incident. We believe that
enterprises are more willing to consider more robust authentication solutions in light of
the inherent costs of password management.
Improved technology at lower cost.USB-based authentication is a relatively new technology
that offers more functionality than traditional OTP devices, at a lower cost. USB tokens
provide an easily integrated strong authentication scheme compared to other hardware-based
tokens such as OTP key fobs and smart cards, which require separate hardware readers. USB
ports are standard on most PCs, requiring no additional hardware and cost.
Increasing adoption of authentication solutions for consumer applications.s on-line
services become more pervasive, financial institutions, e-commerce providers and Internet
service providers are starting to provide their customers with authentication solutions to
ensure secure on-line transactions and prevent consumer fraud.***Content
  security overview***


-13-
Existing
enterprise network infrastructure is susceptible to security attacks, which compromise and
threaten the utility of Internet usage and electronic messaging. Enterprises are
constantly exposed to viruses and spam spawned by access to unauthorized Internet content
and content contained in electronic messages.


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


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


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


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


***Content
  security market trends***


The
content security market is projected to grow from $3.4 billion in 2003 to $7.5 billion in
2008, according to IDC. Sub-segments of content security include:



Messaging security, which is used to monitor, filter and block messages from different
messaging applications, is projected to grow from $397 million in 2003 to $1.7 billion in
2008, representing a compound annual growth rate of 34%; and
Web filtering, which is used to screen and exclude web pages which are deemed
objectionable or not business related, is projected to grow from $338 million in 2003 to
$935 million in 2008, representing a compound annual growth rate of 23%.We
believe that the following are key growth drivers of the content security market:



    **Higher
      frequency of worms and viruses.** Attacks on consumers and corporate
      users have become easier with the proliferation of broadband access. According
      to Viruslist.com, a website focusing on Internet security, the number of
      new threats continues to grow at the rate of several hundred every day.
    **Proliferation
      of spam.**According to IDC, in 2003 spammers sent an average of
      13.5 billion e-mails per day and spam as a percentage of overall Internet
      e-mail traffic is projected to grow from 35% in 2002 to 67% in 2007.
    **Information
      and identity theft.** The widespread use of the Internet for e-commerce
      and e-business has resulted in rapid growth in the number of information
      and identity theft cases. This, in turn, is causing a steadily growing awareness
      of the need for stronger information security. According to Gartner, adults
      in the United States received an estimated 57 million phishing email attacks
      within the last year. Phishing is-14-
the act of
      sending an e-mail to a user falsely claiming to be from an established,
      legitimate enterprise, in an attempt to mislead the user into surrendering
      private information that will be used for identity theft. Direct losses
      to phishing attack victims from identity theft fraudincluding new
      account, checking account and credit card fraudcost U.S. banks and
      credit card issuers about $1.2 billion in 2003.
    **Escalation
      of spyware.** Organizations are becoming increasingly impacted by
      spyware, which steals critical information and user identities. IDC ranks
      spyware as the fourth-greatest threat to network security, well ahead of
      spam and even cyber-terrorism.
    **Increasing
      regulation.**Regulations such as the Gramm-Leach-Bailey Act, the
      Health Insurance Portability and Accountability Act and the Sarbanes-Oxley
      Act, each of which requires enhanced protection of sensitive personal and
      corporate data, have forced organizations to take additional measures to
      protect their networks.Our Solutions


***Software
  DRM***


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



    **Comprehensiveness
      and flexibility.** We provide comprehensive and flexible alternatives
      for software publishers to license their software. Our customers can combine
      hardware-based, software-based and network-based software licensing. Utilizing
      our Protect OnceDeliver Many architecture, software publishers
      can prepare their software for distribution and implement differing licensing
      models for different markets.
Security.Our advanced algorithms and anti-debugging features provide enhanced security to
our customers. The high level of security is achieved through features such as:
    an advanced encryption
      engine that employs state-of-the-art algorithms based on 128 bit Advanced
      Encryption Standard (AES) technology;
    a hardware-based real-time
      clock, enabling time-based licensing and security; and
    remote software updating
      using digitally signed secure files.We believe that no competing
      product offers the combination of such features and the associated level
      of security.
    **Ease
      of use.** Software publishers can protect their products without
      any special programming by applying our proprietary software wrapping technology.
      For end-users, installation of protected software is a simple and transparent
      plug-and-play process.
    **Reliability.**
      We believe our hardware keys are extremely reliable even while operating
      in diverse environments. Our product return rate in 2004 was negligible.***Enterprise
  security***


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


Authentication



    **Enhanced
      security.** eTokens ability to integrate standard hardware
      and software interfaces enables implementation of strong, two-factor user
      authentication. This particular authentication technology using hardware-based
      cryptographic challenge-response enhances security and is not available
      in competing authentication technologies such as biometrics, passwords and
      software-based certificates, which do not utilize a hardware component.-15-

    **Cost
      effectiveness.** Our advanced USB token implementation provides a
      cost-effective solution due to instant USB connectivity offered by most
      PCs today making a special separate smart card reader redundant. Our
      architecture, which is based on the standard operating system interfaces,
      can eliminate the need for a back-end server, reducing the cost of implementing
      the solution. Our standard USB token draws its power from the USB port which
      eliminates the need for batteries and enables its use indefinitely unlike
      competing technologies. The result is a highly cost effective solution for
      implementing strong user authentication.
    **Product
      quality and ease of use.** Years of adaptation to mainstream security
      applications and rigorous field testing, combined with an emphasis on ease
      of use, has positioned the eToken solution as one of the most advanced,
      robust and simple solutions in the market.Content security


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


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


***Extend
  our technology and introduce new products***


We
intend to leverage our technology, product strengths and expertise to further expand our
core product functionality and continue to develop complementary solutions. We will
continue to invest in research and development and expect to announce several new product
and technology offerings during 2005. Current initiatives include developing a unified
hardware and software solution for software DRM based on our HASP solution, adding
additional security functionality to our eToken line of products, including an innovative
biometric solution, and developing additional proactive technologies to fight content
security threats.


***Provide
  customer focus to leverage our existing customer base***


We
believe our dedication to customer service has fostered significant loyalty within our
customer base. In 2004, we believe that a significant portion of our revenues were from
repeat customers. Currently, we are in the process of launching a new, internal customer
relationship management system to further enhance our customer focus. We believe that our
established enterprise security customer base represents a significant opportunity to
cross-sell our other enterprise solutions.


***Establish
  new strategic OEM relationships and other distribution channels***


We market our enterprise
  security products, eToken and eSafe, through indirect channels, including distributors,
  value-added resellers and system integrators, and more recently, through OEM
  relationships. We believe that this strategy allows us to provide our security
  solutions to the largest number of end-users. We intend to increase our
-16-
channel sales to accelerate
  the growth of our enterprise security segment particularly by establishing OEM
  relationships with large technology vendors. For example, in the first quarter
  of 2004, we established an OEM relationship with VeriSign, Inc.


***Pursue
  strategic acquisitions***


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


Our Products


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


***Software
  DRM***


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



HASP HL operates by receiving encrypted strings during runtime from the protected
application and decrypting them in a way which is very difficult to imitate. The decrypted
data that is returned from the HASP HL token is employed in the protected application so
that it affects the mode in which the program runs. As a result, customer software may
load and run, execute only certain components or not execute at all.
HASP HL Net, our most sophisticated hardware-based key, protects software developers from
theft and misuse of their products in the network environment. A single key, connected to
any computer on the network, protects software against illegal use, limits the number of
users who can access the application concurrently and controls access to up to 112
software modules and packages.
HASP SL is a software-based licensing, software protection and distribution system that
protects software copyright and intellectual property and reduces costs for secure
distribution via CD-ROM, ESD or peer-to-peer networks.Enterprise Security


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


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



    **eToken**
      NG OTP is a new hybrid token incorporating smart card technology with a
      one time password. This enables authentication in both connected and disconnected
      modes.
    **eToken**
      PRO USB is a two-factor authenticator that employs a readerless smart card
      and is primarily used for network authentication and digital signing.
    **eToken**
      TMS (Token Management System) is a system used by organizations to help
      manage tokens and smart cards. This product supports applications including
      Web access, secure e-mail, data encryption, network logon and Virtual Private
      Networks, or VPNs.eSafe.eSafe is a gateway-based, integrated content security solution that proactively
  protects networks against viruses, worms, spam and non-productive Internet-borne
  content. eSafe includes antivirus, anti-spam and web filtering and protection
  against unauthorized peer-to-peer (P2P) traffic, adware and spyware. eSafes
  ability to block
-17-
known and unknown viruses
  and other threats is designed to protect critical information and reduce network
  and user downtime.


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


Sales And Marketing


***Sales***


We sell
our software DRM products primarily to software developers and distributors. No one
customer accounted for more than 5% of our total revenues in 2002, 2003 or 2004.


We
market and sell our software DRM solutions directly through our head office in Israel and
through our nine international subsidiaries, including the United States, the United
Kingdom, Germany, Spain, Hong Kong and Japan. In addition, we have 29 distributors
covering additional countries not covered by our subsidiaries. In 2004, we recorded
revenues of $26.7 million, representing 38.6% of our total revenues from sales by
distributors. Under the terms of our distribution agreements, we generally grant to one
distributor in each particular country or region a non-exclusive right to market our
software DRM solutions for an initial term of one year. During this period, the
distributor is required to meet minimum sales targets set out in the distribution
agreement. Following the expiration of the initial period, the distribution agreement with
each distributor is automatically renewed, unless we or the distributor give prior written
notice. Each distributor is responsible for preparing and submitting to us for approval a
marketing plan for sales in that distributors sales territory and for obtaining and
maintaining any local regulatory approvals required to sell our software DRM solutions in
that territory.


We
market and sell our enterprise security solutions, eSafe and eToken, through indirect
channels, which include distributors, value-added resellers and system integrators. In
addition to selling our enterprise security solutions through channel distributors, we are
pursuing a strategy to establish OEM relationships with large technology vendors. In the
first quarter of 2004, we entered into an agreement with VeriSign, Inc., according to
which VeriSign used our eToken NG with OTP functionality for its Unified Authentication
beta program, which began testing in April 2004. VeriSigns Unified Authentication
service with our eToken NG and OTP functionality was made generally available in September
2004.


Cisco
Systems has announced that it is including USB ports and our eToken technology in its new
series of routers, introduced in February 2005. Sales of eTokens are not expected to be
made to or through Cisco, but these routers will enable Cisco customers to easily use our
eToken products for network administrator strong authentication. Given Ciscos large
customer base, we believe that this integration of our technology into these routers will
provide us with a significant sales advantage.


***Marketing***


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. These marketing activities include:



press
releases;
direct
mail and channel-related campaigns;
e-mail
sponsorships and campaigns;
publication
of technical and educational articles in industry journals;
participation
in industry trade shows;
organization
of, and participation in, product/technology conferences and seminars;
competitive
analysis;-18-

sales
training;
advertising
in trade magazines;
Internet
promotion and advertising;
development
and distribution of literature about our company; and
development
and ongoing maintenance of our web site, intranet and extranet.Competition


***Software
  DRM***


Our
software DRM solutions compete with hardware-based systems and software-based systems. In
the hardware-based software licensing authentication token, or SLAT, market, we compete
principally with SafeNet (which recently acquired Rainbow Technologies) and which,
according to IDC, had a 35.1% market share in 2003. We also compete in the SLAT market
with a number of smaller vendors including WIBU Systems AG. In the software-based software
protection market, we face competition from a larger number of vendors, primarily
Macrovision Corporation and SafeNet, which provide software solutions for distribution and
licensing.


***Enterprise
  Security***


     Authentication.In the strong, or two-factor, authentication market, our eToken product line
          competes principally with smart cards and traditional authentication tokens,
          including OTP tokens, which are currently the dominant method of authentication.
          In addition, our eToken product line competes with other USB-based
          authentication systems. Our principal competitor in the authentication market is
          RSA Security which holds a dominant position in the traditional authentication
          token market, in addition to VASCO Data Security International, Inc. and
          ActivCard Corp. We have recently entered into licensing and supply agreements
          with RSA Security. Our principal competitor in the USB-based authentication
          market is SafeNet, in addition to Gemplus Incorporated S.A. and Eutron SpA.
          According to IDC, RSA Security and Rainbow Technologies accounted for 55.2% of
          the global hardware authentication token market in 2003.


Content
security.Our primary competitor in the content security market for
gateway solutions is Trend Micro Inc., which holds a dominant position in this market. The
overall content security market is characterized by a small number of large companies,
such as Symantec Corporation, McAfee Inc. and Trend Micro, which together accounted for
over 60% of global revenues in this market, as well as a large number of small companies.
While the products marketed by these companies are primarily desktop or network server
solutions and not the gateway solution eSafe provides, we may face competition from these
companies in the future if they decide to develop gateway solutions. Vendors of firewalls
might decide to extend their offerings to gateway security, and these could compete with
our eSafe product.


Intellectual Property


We have
devoted 19 years to the development of proprietary information security technologies. We
have also made certain strategic acquisitions that have enabled us to add significant
technologies to our intellectual property portfolio.


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


The software industry is
  characterized by constant product changes resulting from new technological developments,
  performance improvements and lower hardware costs. We believe that our future
  growth depends to a large extent on our ability to be an innovator in the development
  and application of hardware and software technology. We have adopted a policy
  of registering patents to protect our core technologies in the enterprise security
  segment. We hold two patents for the technology underlying eToken and have several
  patent applications pending for NitroInspection technology in on-line web content
  security, which provides fast throughput and scalable network implementation.
-19-
One U.S. and one European
  NitroInspection patent application have been rejected, and we are currently
  appealing the rejection of the U.S. application. We cannot be certain that any
  patents, or patents that are advantageous to us, will be issued. On January
  31, 2005, we announced that RSA Security has licensed two of our patents relating
  to our eToken technology. We believe that this license to a market leader in
  strong, two factor authentication technology supports the strength of our intellectual
  property portfolio in this segment of our business. We do not substantially
  rely on patent protection with regard to our software DRM products. As of December 31,
  2004, we had 19 registered patents and 41 pending applications in the United
  States. We also had 10 registered patents and 26 pending applications outside
  of the United States, including seven patent applications filed pursuant to
  the Patent Cooperation Treaty.


Government Regulation


***Regulation
  of Encryption Technologies***


Our
eToken and HASP product lines contain encryption technologies which require a permit from
the Israeli government for their development and export. We have obtained a general permit
for our HASP HL product, which does not require renewal, and we have a special permit to
export eToken, which requires annual renewal. We also conduct some of our research and
development activities in Germany and may be subject to regulations regarding export of
technologies. We are not currently aware of the scope of, or our compliance with, such
regulations.


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


***Environmental
  Regulation***


Our
European activities also require us to comply with Directive 2002/95/ec of the European
Parliament on the Restriction of the Use of Certain Hazardous Substances in Electrical and
Electronic Equipment (the RoHS Directive) which will take effect on July 1, 2006.
This directive provides that producers of electrical and electronic equipment may not
place new equipment containing lead, mercury and certain other materials deemed to be
hazardous, in amounts exceeding the set maximum concentration values, on the market in the
European Union. Certain of our products must be modified to meet this regulation, and some
of our distributors and customers are already requiring us to comply with these new rules
so as not to be left with noncompliant inventory when the directive takes effect.
Complying with this directive will impose some additional costs and administrative burden
on us.


Manufacturing


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


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


-20-

    **HASP.**
      We obtain each of the application specific integrated circuits and microcontrollers
      included in HASP from sole source suppliers.
    **eToken.**
      We obtain the microcontroller and the smart card, including its operating
      system, for our eToken products from sole source suppliers.We do
not have any long term supply arrangements with any of our suppliers with respect to these
key components. We estimate that it would take between six months and one year to find
alternate suppliers for these key components and modify our products to incorporate them.
We believe that our inventory of each of the key components referred to above is
sufficient to enable us to continue manufacturing our products in the event that we need
to change one of our single source suppliers. Nevertheless, we may encounter delays or
difficulties in redesigning our products and may not be able to locate alternate suppliers
on a timely basis. If an adequate supply of any of these components is not obtained in a
timely manner or at all, we may have difficulty meeting our production needs.


We
license the anti-spam and web filtering functions incorporated in our eSafe product
pursuant to a license agreement which expires in June 2005. We pay our licensor royalties
consisting of a percentage of our revenues from eSafe. In the event that our licensor does
not renew this license arrangement with us, we will be required to seek an alternate
licensor for these functions.


C. ORGANIZATIONAL
STRUCTURE


We have four operating subsidiaries
  of which three are direct wholly-owned: Aladdin Knowledge Systems, Inc., incorporated
  in the state of New York; Aladdin Japan & Co. Inc., incorporated in Japan;
  Aladdin Western Europe Ltd. (formerly Aladdin Knowledge Systems UK Ltd), incorporated
  in England and Wales. The fourth, Aladdin Asia Limited, which is incorporated
  in Hong Kong, is 99% owned by us, with the remaining 1% shareholding owned by
  our wholly-owned holding company, Hafalad BV. These subsidiaries are all involved
  in distribution, support for and management of our products.


In addition we have a wholly-owned
  holding company, Hafalad BV, which is incorporated in The Netherlands. Hafalad
  has the following wholly-owned subsidiaries: Aladdin Western Europe BV, incorporated
  in The Netherlands; Aladdin Western Europe S.A.R.L. (formerly Aladdin France
  S.A.), incorporated in France; Aladdin Knowledge España S.L., incorporated
  in Spain; and Aladdin Knowledge Systems Deutschland GmbH, incorporated in Germany.
  These subsidiaries are all involved in distribution, support for and management
  of our products. In addition, our German subsidiary provides us with research
  and development services.


D. PROPERTY, PLANTS AND
EQUIPMENT


Our
corporate headquarters, principal research and development facilities, and certain of our
manufacturing facilities are located in a 29,121 square foot facility in Tel Aviv, Israel.
The lease for this facility expires in August 2006 and we have an option to extend the
lease for an additional period of one year, until August 2007 and an additional option to
extend the lease as to 26,947 square feet of this facility until August 2011. Our
manufacturing facility is located in a 10,521 square foot facility in Kiryat Gat, Israel.
We lease this facility pursuant to a lease that expires in September 2005. We also lease a
11,883 square foot facility in Tirat Hacarmel, Israel for a term expiring in December
2007, where our Internet security research and development activities are headquartered,.


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


Our
aggregate annual lease expenses in 2004 for our facilities were $1.9 million. We believe
that our facilities are adequate for our current needs, and that we will be able to find
additional or alternate facilities if we require them or if we are unable to renew our
existing leases on reasonable terms or at all.


Item 5. Operating
  and Financial Review and Prospects


You should read the following
  discussion together with our consolidated financial statements, related notes
  and other financial information included elsewhere in this annual report. This
  discussion may contain
-21-
predictions, estimates
  and other forward-looking statements that involve risks and uncertainties, including
  those discussed under Risk Factors and elsewhere in this report.
  These risks could cause our actual results to differ materially from any future
  performance suggested below.


OVERVIEW


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


We were
established in 1985 with our principal focus on software protection through our HASP
product line. Between 1996 and 2004, we completed five acquisitions of businesses and
product lines which broadened our product offering and enhanced our research and
development, direct marketing and selling capabilities. We acquired our eSafe product line
at the end of 1998. In 1999, we entered the enterprise security market by complementing
eSafe with our eToken product line. As a result of the additional expenses incurred in
this transition, as well as generally adverse economic conditions, we incurred net losses
in 2001 and 2002. In 2003 and subsequent interim periods, we returned to profitability. At
the start of 2004, we constituted our enterprise security segment as a separate reportable
segment. In 2004, we generated 73% of our revenues from our software DRM segment and the
balance from our enterprise security segment. We introduced the latest versions of our
HASP product line, HASP HL and HASP SL (formerly our Privilege product) in the
third quarter of 2004.


Reportable segments


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


Year ended December 31,2002
     2003
     2004Software DRM
     
     
     81.0
        %
     79.5
        %
     73.3
        %Enterprise security
     19.0
        
     20.5
        
     26.7Revenues


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


In 2003
and 2004, part of our revenues was denominated in Euros, Japanese Yen and British pounds,
all of which have significantly appreciated versus the U.S. dollar during this period of
time.


When
translating these revenues into U.S. dollars for the purposes of preparing our
consolidated financial statements, one of the effects of this appreciation was to increase
our reported revenues. In our period to period discussion below, we have indicated the
effects of currency fluctuations on our revenues in our reported segments. We also refer
you to Item 11,Quantitative and Qualitative Disclosures About Market Risk
below in this report for disclosure of the effect of changes in exchange rates on our
overall revenues, gross profit and income (loss) from operations for the years ended
December 31, 2002, 2003 and 2004.



-22-
***Revenue
  recognition***


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

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


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


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


Our
deferred revenues as of December 31, 2003 were $3.4 million and as of
December 31, 2004 were $4.8 million. This increase was primarily due to an increase
in time-based license revenues.


***Revenue
  trends and drivers***


Customer
concentration.We sell our products to a large number of customers. In the past three
years, no customer accounted for more than 5% of our revenues.


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

Year ended
      December 31,2002
     2003
     2004United States
     35%
     32%
     29%Europe (excluding Germany)
     27
     25
     27Germany
     19
     22
     22Japan
     9
     13
     13Israel
     4
     4
     4Others
     6
     4
     6Repeat
customers.We consider the proportion of our revenues from repeat customers to be an
important tool in analyzing our business in our software DRM segment. We believe that a
significant portion of our revenues in 2004 were from repeat customers.


Cost of revenues and
gross profit


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


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


-23-
Our
gross margin is impacted principally by the mix of hardware- and software-based solutions
that we sell due to the higher cost of revenues associated with hardware-based solutions.


Operating expenses


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


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


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


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


Taxes
on income.Although Israeli companies generally are subject to income tax at the
corporate rate of 35% in 2004, we benefit from Israeli government tax exemption programs
that reduce our effective tax rate as described under the caption Corporate
Tax.


CRITICAL ACCOUNTING
POLICIES AND ESTIMATES


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


Allowance for doubtful
accounts


We are
required to perform ongoing credit evaluations of our trade receivables and maintain an
allowance for doubtful accounts, based upon our judgment as to our ability to collect
outstanding receivables. Provisions are made based upon a specific review of all the
outstanding invoices. In determining the provisions, we analyze our historical collection
experience, current economic trends and the financial position of our customers. If the
financial condition of our customers deteriorates, our revenues might be limited and
additional allowances might be required. As of December 31, 2004, our allowance for
doubtful accounts was $995,000 and our trade receivables were $12.6 million. To date, our
allowances for doubtful accounts have been sufficient.


Inventories


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


-24-
Taxes on income and
deferred tax


We
account for income taxes using the asset and liability method. Deferred tax assets net of
valuation allowances, totaled $1.7 million as of December 31, 2004. Deferred tax
assets, related valuation allowances and deferred tax liabilities are determined
separately by tax jurisdiction. We believe sufficient uncertainty exists regarding our
ability to realize our deferred tax assets in certain foreign jurisdictions and,
accordingly, a valuation allowance has been established against the deferred tax assets in
those jurisdictions. We believe that it is more likely than not that the results of future
operations will generate sufficient taxable income to utilize the remaining deferred tax
assets, net of valuation allowances. While we have considered future taxable income and
ongoing tax planning strategies in assessing the need for any valuation allowance, in the
event we were to determine that we will be able to realize our deferred tax assets in the
future in excess of the net recorded amount, an adjustment to the valuation allowance
would increase income in the period such a determination is made. Likewise, should we
determine that we would not be able to realize all or part of our net deferred tax assets
in the future, an adjustment to the valuation allowance would be charged to income in the
period such a determination is made. Our effective tax rate is directly affected by the
relative proportions of domestic and international revenue and income before taxes, as
well as the estimated level of annual pre-tax income. We are also subject to changing tax
laws in the multiple jurisdictions in which we operate.


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


Goodwill


Under
Statement of Financial Accounting Standard No. 142, Goodwill and Other
Intangible Assets (SFAS No. 142), goodwill acquired in a business
combination that closes on or after July 1, 2001 is deemed to have indefinite life
and will not be amortized. SFAS No. 142 requires goodwill to be tested for impairment
on adoption and at least annually thereafter or between annual tests in certain
circumstances, and written down when impaired, rather than being amortized as previous
accounting standards required. Goodwill is tested for impairment by comparing the fair
value of the reporting unit with its carrying value. Fair value is determined using the
income approach. Significant estimates used in the methodologies included estimates of
future cash flows and estimates of discount rates. We have performed impairment tests on
our goodwill and as of December 31, 2004, no impairment losses have been identified.
As of December 31, 2004, we had total goodwill of $7.7 million on our balance sheet.
In assessing the recoverability of our goodwill and other intangible assets, we must make
assumptions regarding the estimated future cash flows and other factors to determine the
fair value of the respective assets. If these estimates or their related assumptions
change in the future, we may be required to record impairment charges for these assets.


Impairment of long-lived
assets


Under
Statement of Financial Accounting Standard No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, long-lived assets, such as property and
equipment, and purchased intangibles subject to amortization, are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of an asset
group may not be recoverable. Recoverability of assets to be held and used is measured by
a comparison of the carrying amount of an asset group to estimated undiscounted future
cash flows expected to be generated by the asset group. If the carrying amount of an asset
group exceeds its estimated future cash flows, an impairment charge is recognized in the
amount by which the carrying amount of the asset group exceeds the fair value of the asset
group. Assets to be disposed of would be separately presented on the balance sheet and
reported at the lower of the carrying amount or fair value less costs to sell, and would
no longer be depreciated. The assets and liabilities of a disposal group classified as
held for sale would be presented separately in the appropriate asset and liability
sections of the balance sheet. In 2002, 2003 and 2004, no impairment charges were recorded
for long-lived assets.


Investment in other
companies


We have investments in two
  related investment funds managed by Tamir Fishman Ventures Management II
  Ltd. The investment is stated at cost since we do not have the ability to exercise
  significant influence over operating and financial policies of the investee.
  Our management reviews our investment for impairment whenever events or
-25-
changes in circumstances
  indicate that the carrying amount of an investment may not be recoverable. In
  2002, we realized an impairment charge of $1.0 million related to these investments
  and we may realize additional impairment charges in the future.


Litigation


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



-26-
RESULTS OF OPERATIONS


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



Year ended December 31,2002
     2003
     2004Revenues:Software security
     81.0
        %
     79.5
        %
     73.3
        %Enterprise security
     19.0
        
     20.5
        
     26.7Total revenues
     100.0
        
     100.0
        
     100.0Cost of revenues:Software security
     17.0
        
     14.6
        
     13.8Enterprise security
     3.7
        
     3.3
        
     6.1Total cost of revenues
     20.7
        
     17.9
        
     19.9Gross profit
     79.3
        
     82.1
        
     80.1Operating expenses:Research and development
     24.7
        
     23.3
        
     17.4Selling and marketing
     44.4
        
     40.2
        
     35.7General and administrative
     14.6
        
     14.2
        
     12.7Total operating expenses
     83.7
        
     77.7
        
     65.8Operating income (loss)
     (4.4
        )
     4.4
        
     14.3Financial income, net
     1.0
        
     0.9
        
     0.1Other expenses, net
     (1.9
        )
     0.0
        
     (0.2
        )Income (loss) before taxes onincome
     (5.3
        )
     5.3
        
     14.2Taxes (benefit) on income
     5.6
        
     0.1
        
     1.4Income (loss) before equity inlosses of an affiliate
     (10.9
        )
     5.2
        
     12.8Equity in losses of an affiliate
     (2.5
        )
     (0.2
        )
     0.0Net income (loss)
     (13.4
        )%
     5.0
        %
     12.8
        %Year ended December 31,
2004 compared to year ended December 31, 2003

Revenues


Total
revenues increased by 26.3% to $69.1 million in 2004 from $54.7 million in 2003. Currency
fluctuations accounted for $3.3 million of this increase.


Software
DRM.Revenues from software DRM increased by 16.4% to $50.6 million in 2004 from $43.5
million in 2003. This increase was attributable to increased sales of our HASP products in
all geographic markets. This increase in HASP product sales resulted from an increase of
13.6% in the number of HASP keys sold in 2004 compared to 2003.


Enterprise security.Revenues
  from enterprise security increased by 64.9% to $18.5 million in 2004 from $11.2
  million in 2003. This increase was attributable primarily to increased revenues
  of $1.5 million from greater penetration of eSafe to larger customers and increased
  revenues of $1.7 million from time-based licenses for additional eSafe features.
  This greater penetration of eSafe to larger customers led to an increase in
  the number of the licenses sold in 2004 by 17% compared to 2003. The increased
  revenues from the new time-based licenses for
-27-
additional eSafe features
  resulted from a significant increase in the number of sales of these licenses
  in 2004 compared to 2003, when these sales had just begun and the recognized
  revenues were immaterial. In addition, revenues from eToken increased by $4.0
  million due to increased market acceptance. This increase in eToken sales resulted
  from an increase of 100.0% in the number of eToken keys sold in 2004 compared
  to 2003.


Cost of revenues


Total
cost of revenues increased by 40.6% to $13.8 million in 2004 from $9.8 million in 2003.
Currency fluctuations accounted for $110,000 of this increase.


Software
DRM.Cost of revenues for software DRM increased by 19.3% to $9.5 million in 2004 from
$8.0 million in 2003. This increase was primarily attributable to an increase in
manufacturing costs of $953,000 due to the increase in sales and an increase of $564,000
as a result of a reassignment of technical support personnel from the research and
development and sales departments to customer support. Gross margin from software DRM
products remained relatively stable at 81.2% in 2004 compared with 81.6% in 2003.


Enterprise
security.Cost of revenues for enterprise security increased by 135.0% to $4.2 million
in 2004 from $1.8 million in 2003. This increase was primarily attributable to an increase
in manufacturing costs of $1.2 million due to the increase in sales and an increase of
$920,000 as a result of a reassignment of technical support personnel from the research
and development and sales departments to customer support. Gross margin from enterprise
security decreased to 77.0% in 2004 compared with 83.9% in 2003.


Gross
profit increased by 23.2% to $55.3 million in 2004 from $44.9 million in 2003. Our gross
margin decreased to 80.1% in 2004 from 82.1% in 2003.


Research and development


Research
and development expenses decreased by 5.7% to $12.0 million in 2004 from $12.8 million in
2003. This decrease resulted primarily from the reassignment of technical support
personnel from the research and development department to customer support which decreased
research and development costs by $454,000. The balance of the decrease was attributable
to a shift of our research and development efforts in the software DRM segment from the
United States to Israel resulting in reduced labor and facility costs of $498,000. As a
percentage of revenues, research and development expenses decreased to 17.4% in 2004 from
23.3% in 2003.


Selling and marketing


Selling
and marketing expenses increased by 12.1% to $24.7 million in 2004 from $22.0 million in
2003. This increase was primarily attributable to an increase of $1.2 million in salaries
and an increase of $608,000 in commissions to sales personnel, an increase of $1.1 million
in general marketing expenses and an increase of $285,000 in travel expenses. This
increase was partially offset by a decrease of $1.0 million in expenses resulting
from the reassignment of technical support personnel from the sales department to customer
support. As a percentage of revenues, selling and marketing expenses decreased to 35.7% in
2004 from 40.2% in 2003. Currency fluctuations accounted for $1.2 million of the
total increase in selling and marketing expenses in 2004.


General and
administrative


General
and administrative expenses increased by 13.7% to $8.8 million in 2004 from $7.7 million
in 2003. This increase was primarily attributable to an increase of $466,000 in salaries,
mainly due to bonus expenses of $220,000, an increase of $200,000 in amortization expenses
as a result of a settlement agreement with Aladdin Systems Holdings Inc. and an increase
of $322,000 in other general items. As a percentage of revenues, general and
administrative expenses decreased to 12.7% in 2004 from 14.2% in 2003.


Financial income, net


Financial
income, net, in 2004 was $53,000 compared to financial income, net, of $480,000 in 2003.
This change was primarily attributable to the decrease in our financial income related to
foreign currency reimbursement gains resulting from currency fluctuations.


-28-
Taxes on income


Taxes
on income were $957,000 in 2004 compared to $49,000 in 2003. Taxes on income in 2003, in
an amount of $399,000, were partially offset by an increase in the deferred tax asset of
$350,000 related to certain foreign net operating losses carried forward.


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


Revenues


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


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


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


Cost of revenues


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


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


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


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


Research and development


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


Selling and marketing


Selling and marketing expenses
  remained essentially the same in 2003 compared to 2002 and totaled $22.0 million.
  The stability in selling and marketing expenses was attributable to an increase
  in sales commissions in the amount of $410,000 due to the growth in our revenues
  in 2003, which was offset by a decrease of $313,000 in employment
-29-
costs due to consolidation
  of our selling and marketing efforts in Europe. As a percentage of revenues,
  selling and marketing expenses decreased to 40.2% in 2003 from 44.4% in 2002.


General and
administrative


General
and administrative expenses increased by 6.9% to $7.7 million in 2003 from $7.2 million in
2002. This increase was primarily attributable to an increase in legal fees due to legal
proceedings that we were involved in either as a plaintiff or defendant. As a percentage
of revenues, general and administrative expenses decreased to 14.2% in 2003 from 14.6% in
2002. Currency fluctuations accounted for $130,000 of the total increase in general and
administrative expenses during this period.


Financial income
(expenses), net


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


Other expenses, net


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


Taxes (benefit) on income


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


LIQUIDITY AND CAPITAL
RESOURCES


Our
primary sources of liquidity are our cash, cash equivalents and marketable securities and
our cash flow from operations. As of December 31, 2004, we had cash, cash equivalents
and marketable securities aggregating $25.9 million. On March 30, 2005, we closed an
underwritten public offering of 2,000,000 ordinary shares resulting in estimated net
proceeds to us of $39.2 million after deducting the underwriting discount and estimated
offering expenses.


Our
operating activities provided cash in the amount of $8.7 million in 2004 compared to $5.9
million in 2003. This increase was primarily due to an increase in net income in the
amount of $6.0 million and an increase of trade payables in the amount of $1.3 million,
which was partially offset by a decrease in inventories in the amount of $835,000, an
increase of trade receivables in the amount of $1.1 million, an increase in other accounts
receivable and prepaid expenses in the amount of $1.4 million and a decrease in accrued
expenses and other accounts payable in the amount of $1.7 million. Our operating
activities provided cash in the amount of $5.9 million in 2003 and $4.2 million in 2002.
This improvement was primarily attributable to our moving from a net loss to a net income
position.


-30-
Our
investing activities used cash in the amount of $13.6 million in 2004 due to the
acquisition of our former distributor, Aladdin Knowledge España S.L., for an amount
of $1.8 million (net of cash on hand), an investment in Tamir Fishman Ventures II LLC
in the amount of $1.3 million, an investment in Idesia Ltd. in the amount of $1.1 million,
an investment in available-for-sale marketable securities in the amount of $7.0 million,
the purchase of property and equipment in the amount of $1.2 million and the purchase of
intangible assets in the amount of $1.2 million. Our investing activities used cash in the
amount of $2.6 million in 2003 due to the purchase of property and equipment in the amount
of $913,000 and an investment in Tamir Fishman Ventures II LLC in the amount of $1.7
million. Our investing activities used cash in the amount of $2.5 million in 2002
primarily due to the purchase of property and equipment in the amount of $1.1 million, and
an investment in and loans to affiliates in the amount of $1.0 million.


Our
financing activities provided cash in the amount of $3.6 million in 2004 and $456,000 in
2003 due to proceeds from the exercise of stock options by employees. In 2002, our
financing activities did not use or provide any cash.


We had
working capital of $34.3 million as of December 31, 2004, $26.6 million as of
December 31, 2003 and $22.7 million as of December 31, 2002.


The
following table summarizes our contractual obligations and commercial commitments as of
December 31, 2004:


Payment due by periodContractual obligations
     Total
     Less
than 1
year
     2
years
     3
years
     4
years
     After 4
years(in thousands)Operating
      leases (1)

    

    

    $
    5,409

    

    $
    2,554

    

    $
    1,760

    

    $
    813

    

    $
    156

    

    $
    126Purchase obligations (2)
     2,060
        
     618
        
     721
        
     721
        
     
        
     Other long-term
      commitment (3)
    
    

    
    2,251

    

    
    1,704

    

    
    547

    

    
    

    

    
    

    

    
    Total contractual
      obligations
    
    

    $
    9,720

    

    $
    4,876

    

    $
    3,028

    

    $
    1,534

    

    $
    156

    

    $
    126(1)
    Consists of operating
      leases for our facilities and for vehicles.(2)
    Consists of purchase
      orders for components for our products. In some cases, we are entitled to
      terminate our commitment upon agreed advance notice, which is subject
      to a penalty.(3)
    In 2000, we signed
      an agreement with Tamir Fishman Ventures Management II Ltd. and Tamir
      Fishman Ventures II LLC pursuant to which we committed to invest
      up to $8.5 million (of which $6.3 million had been invested at December 31,
      2004) in Tamir Fishman Ventures II LLC at their request. We
      based our assumption of the timing of future investments based on our past experience, since we cannot foresee when the demands will be placed.Our
obligation for accrued severance pay under Israels Severance Pay Law as of
December 31, 2004 was $3.1 million, of which $2.4 million was funded through deposits
into severance pay funds, leaving a net obligation of $700,000.


We
believe that our accumulated cash, in conjunction with cash generated from operations and
available funds, will be sufficient to meet our cash requirements for working capital and
capital expenditures for at least the next 12 months.


INVESTMENTS


Idesia Ltd.In April
  2004, we entered into a convertible loan agreement with Idesia Ltd. (formerly
  known as C-Signature Ltd.), an Israeli company engaged in the development of
  biometric identity recognition technology. Pursuant to the agreement, we invested
  an aggregate amount of $1,050,000 in Idesia. This investment consisted of a
  $550,000 convertible loan, which automatically converted into Series A preferred
  shares of Idesia upon the
-31-
achievement of certain agreed
  upon milestones. Concurrently with the conversion of the loan, we invested the
  remaining $500,000 by purchasing additional Series A preferred shares of Idesia.
  Following conversion of the loan and the closing of the purchase, we hold 19.9%
  of the share capital of Idesia. We intend to execute a cooperation and technology
  license agreement with Idesia pursuant to which we will develop a line of commercial
  products based on Idesias technology, and Idesia will grant us a license
  to its technology.


Athena Research Ltd.In
  December 1998, we signed a strategic agreement with Athena Research Ltd. (our
  former partner in Aladdin Knowledge Systems Japan Co.) pursuant to which we
  formed an entity named Athena Smart Card Solutions Ltd. which develops and markets
  smart card solutions. We invested an aggregate of $542,000 in the share capital
  of Athena, representing a 35.7% ownership interest, and made aggregate loans
  of $2.5 million. In April 2005, as a result of a financial restructuring of
  Athena, we forgave the $2.5 million loans and our ownership position was diluted
  to 19.6%. The restructuring had no effect on our financial condition or results
  of operations in the year ended December 31, 2004, as both the investment in
  equity and the entire loan had been written-off in previous years.


CORPORATE TAX


Israeli
companies generally are subject to income tax at the corporate rate of 35% for the 2004
tax year, 34% for the 2005 tax year, 32% for the 2006 tax year and 30% for the 2007 tax
year and thereafter. We benefit from Israeli government tax exemption programs that reduce
our effective tax rate. We currently have two effective expansion programs that have been
granted approved enterprise status and one expansion program currently in the process of
implementation prior to obtaining final approval. Therefore, we are eligible for tax
benefits under the Israeli Law for the Encouragement of Capital Investments, 1959. The tax
benefits from the two effective programs expire at the end of 2006 and 2008, respectively.
We also have one expansion program that expired at the end of 2004 for which we enjoyed
tax benefits. Subject to compliance with applicable requirements, the portion of our
undistributed income derived from our approved enterprise programs was exempt from income
tax during the first two or four years in which these investment programs produced taxable
income and are currently subject to a reduced tax rate of between zero and 20% for the
remaining six or eight years of the program, depending on the program. In order to enjoy
these benefits, we have determined not to declare dividends or otherwise distribute
earnings out of tax exempt income. The availability of these tax benefits is subject to
certain requirements, including making specified investments in property and equipment,
and financing a percentage of investments with share capital. If we do not meet these
requirements in the future, the tax benefits may be canceled and we could be required to
refund any tax benefits that we have already received, plus interest and penalties
thereon. See Item 10 Additional Information  Section E.Israeli
Taxation Since our taxable income is derived from more than one approved enterprise
program and since part of our taxable income is not derived from an approved enterprise
(including any taxable income of our subsidiaries), our effective tax rate is a weighted
average rates based on the various applicable rate and tax exemptions.


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


As of
December 31, 2004, the net operating loss carry-forwards of our subsidiaries for tax
purposes amounted to $26.5 million, the majority of which related to our U.S. and German
subsidiaries. A subsidiarys net operating loss carry-forwards for tax purposes
relating to a jurisdiction are generally available to offset future taxable income of such
subsidiary in that jurisdiction, subject to applicable expiration dates.


Item 6. Directors,
Senior Management and Employees


A. DIRECTORS AND SENIOR
MANAGEMENT


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



Name
    Age
    PositionJacob
      (Yanki) Margalit
    43
    Chairman
      of the Board and Chief Executive Officer-32-
Name
    Age
    PositionDany Margalit
    37
    Director
      and Executive Vice President, TechnologiesErez Rosen
    44
    Chief Financial
      OfficerAmi Dar
    44
    President
      of Aladdin Knowledge Systems Inc.Steve Langerock
    50
    Chief Executive
      Officer of Aladdin Knowledge Systems Inc.Aviram
      Shemer
    34
    Vice President,
      FinanceLeedor
      Agam
    41
    Vice President,
      eBusiness and eToken SolutionsDror Irani
    45
    Vice President,
      eSafe Business Unit ManagerAvishai
      Ziv
    45
    Vice President,
      Business DevelopmentShimon
      Gruper
    44
    Executive
      Vice President, Internet TechnologiesAvi Barir
    50
    Vice President,
      Software DRMRami Chanan
    37
    Vice President,
      Information Systems and OperationsElinor
      Nissensohn
    31
    Vice President,
      Customer RelationsDavid Assia(1)
    53
    DirectorMenahem
      Gutterman(1)(2)
    65
    DirectorOrna Berry(1)(2)
    55
    Director
(1)
    Member of the audit
      committee and independent director under The Nasdaq National Market listing requirements*(2)*
    *External
        director under the Israeli Companies Law*Jacob
(Yanki) Margalitfounded our company in 1985 and has served as our Chairman of the
Board and Chief Executive Officer since 1987. Mr. Margalit served as our Chief Financial
Officer from 1987 to 1993 and has served as a director since 1985. Jacob Margalit is the
brother of Dany Margalit.


Dany
Margalitjoined 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. Dany Margalit is the brother of Jacob Margalit.


Erez
Rosenhas served as our Chief Financial Officer since 1998. In 1997, Mr. Rosen served
as the head of finance and administration of NDS Technologies, a provider of digital
pay-TV solutions and 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 in Germany and Italy by the BASF Group, a chemical
company, where he served in various finance and administration positions. Mr. Rosen holds
a B.A. in economics from the Hebrew University in Jerusalem and an M.B.A. from INSEAD in
Fontainebleau, France. Mr. Rosen completed the General Manager Program at Harvard
Business School.


Ami
Darhas served as President of Aladdin Knowledge Systems, Inc. since October 1993.
From 1988 to 1993, Mr. Dar served as our International Marketing Manager.


Steve
Langerockhas served as Chief Executive Officer of Aladdin Knowledge Systems, Inc.
since 1999. Prior to that, Mr. Langerock served as President of our Software Commerce
Division since 1998 and joined us in 1996 as Chief Financial Officer of Aladdin Knowledge
Systems, Inc. Mr. Langerock joined Glenco Engineering, a manufacturer and marketer of
hardware-based software security solutions, 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 provider of test equipment for the
semi-conductor industry. Mr. Langerock holds a B.A. in business management and accounting
from Carthage College and is a CPA and certified personal investment manager. Mr.
Langerock completed the General Manager Program at Harvard Business School.


Aviram
Shemerhas served as our Vice President, Finance since March 2005. Mr. Shemer joined
our company as an assistant controller in 1999 and became our Director of Finance in 2003.
Mr. Shemer holds a B.A. in accounting and economics and an M.B.A. both from Tel Aviv
University. He is also a certified public accountant in Israel.


-33-
Leedor
Agamjoined us in January 2001 as Vice-President, eBusiness and eToken Solutions, and
is now heading the token authentication business unit. Prior to that, Mr. Agam served as
Vice President of Business Development for Cylink/AR, a hardware and software security
developer. Mr. Agam holds a bachelors of technology in industrial management from
Tel Aviv University and an executive M.B.A. from City University School in London.
Mr. Agam completed the General Manager Program at Harvard Business School.


Dror
Iranijoined us in 1999 and has served as Vice President, eSafe Business Unit Manager,
since January 2003. From May 2000, Mr. Irani served as Global Vice President of Sales.
Prior to that, from 1993 to 1998, he served in executive roles in sales and marketing at
Efrat Future Technologies Ltd., a marketer of communications processing systems, and
Comverse Network Systems, a software and systems provider for wireless and wireline
communications service providers, both in Israel and in the United States. Mr. Irani holds
a B.Sc. in computer science, an M.A. in economics and an M.B.A. from Hebrew University in
Jerusalem and has completed the General Manager Program at Harvard Business School.


Avishai
Zivhas served as Vice President, Business Development since 2001. From 1996 to 2000,
Mr. Ziv served as Chief Executive Officer of C.D.I. Systems Ltd., a developer of
electronic publishing technology. From 1991 to 1996, Mr. Ziv 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 B.A. in
political science and labor studies from Tel Aviv University.


Shimon
Gruperhas served as Executive Vice President, Internet Technologies since 1998. Mr.
Gruper founded and served as Chief Executive Officer of EliaShim Ltd., a digital security
provider, from 1983 until it was acquired by us in 1998.


Avi
Barirhas served as Vice President, Software DRM since 2000. From 1999 to 2000, Mr.
Barir served as the Vice President of Marketing in Alvarion Ltd. (formerly BreezeCom
Ltd.), 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 Access
Solutions SBU, a provider of integrated network solutions. He has also held various
research and development and sales positions in the defense industry and in the
information technology industry. Mr. Barir holds a B.Sc. in Electronics Engineering from
The Technion-Israel Institute of Technology and an M.B.A. from Tel Aviv University.


Rami
Chananhas been Vice President, Information Systems and Operations since 2004. Prior
to that, from 2003 to 2004, Mr. Chanan was the Vice President of Operations for Zag
Industries Ltd., a plastics company. Prior to that, from 2001 to 2002, Mr. Chanan served
as a General Manager of Sanctum Inc., now a subsidiary of Watchfire Corporation, a web
security company. Prior to that, from 2000 to 2001, Mr. Chanan was the founder and CEO of
e-Ting.com, a software company that provided on-line budget monitoring for
corporate-employee relationships. Mr. Chanan holds a B.A. in international marketing from
Tel Aviv College of Business and an M.B.A. from Northwestern Universitys School of
Management.


Elinor
Nissensohnjoined us in 2003 as a Business Development Manager and has served as Vice
President, Customer Relations since March 2005. From July 2004,
Ms. Nissensohn served as a Customer Relations Manager. Prior to that, from 1999 to
2000, Ms. Nissensohn served as an attorney in the business development department of
Bezeq, Israels leading telephone service provider. Ms. Nissensohn holds an LL.B
degree from Tel Aviv University and an M.B.A. from Columbia Business School. She is also a
member of the Israeli Bar.


David
Assiahas served as a director since 1993. Mr. Assia is a co-founder of Magic Software
Enterprises Ltd., a provider of development and integration technology, and Mashov
Computers Ltd. (currently Formula Vision), a software holding company. 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., a developer of verification software,
Babylon Ltd., a developer of translation software and the Weizmann Institute of Science.
Mr. Assia holds a B.A. in economics and statistics and an M.B.A. from Tel Aviv University.



Dr. Menahem Guttermanhas served as an external director since 2000. Dr. Gutterman is a Senior
  Managing Partner of Atid Capital Partners, an Israeli venture capital fund.
  Dr. Gutterman has served as Executive Vice President and
-34-
Head of the Operations Information
  Systems Division of Israel Discount Bank Ltd since 1992. Dr. Gutterman served
  as General Managers Assistant at Israel Discount Bank Ltd. from 1981 to
  1992. Prior to joining Israel Discount Bank Ltd., from 1981 to 1982, Dr. Gutterman
  served as Vice President of Sales and Services at Elscint Limited, then a medical
  imaging devices company, as well as Managing Director of Clal Systems Ltd.,
  from 1974 to 1980. Until 2000, Dr. Gutterman served as a senior lecturer at
  Tel Aviv University, Faculty Management, and School of Business Administration.
  Dr. Gutterman holds a D.Sc. in mathematics from The Technion-Israel Institute
  of Technology.



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


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


B. COMPENSATION


For the
year ended December 31, 2004, we paid in the aggregate approximately $2.1 million as
direct remuneration to our directors and officers. 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 $117,000 to provide pension, retirement or similar benefits.


The
compensation paid to our directors, including to our directors who are also executive
officers, is subject to shareholder approval at our annual general meeting of
shareholders. The following is a summary of the terms of compensation submitted for
shareholder approval:


Non-executive
directors.In 2003, our shareholders approved the grant to each of these directors of
options to purchase 2,500 of our ordinary shares at an exercise price of $2.67 per share
vesting over a four-year period. Beginning in 2005, we will grant to each outside director
options to purchase 4,000 shares annually until such outside directors term expires,
or in the case of Mr. Assia, for three years. Our non-executive directors also receive
annual fees for board and committee membership.


Jacob
(Yanki) Margalit. Effective October 2002, the annual base salary of Jacob (Yanki)
Margalit, our Chairman and Chief Executive Officer, is $150,000. In addition, since the
first quarter of 2002, Mr. Margalit has received an annual performance-based bonus
equivalent to 1.5% of year-to-year increases in our annual revenues. Since the first
quarter of 2002, Mr. Margalit also has received a quarterly performance-based bonus
equivalent to 3.0% of our quarterly net profits. Under this arrangement, in 2004 Mr.
Margalit was entitled to a cash bonus in the amount of $480,000. Of this amount, $167,000
was paid to him, and he has waived his right to receive the remaining $313,000. In April
2003, we granted to Mr. Margalit options to purchase 100,000 of our ordinary shares at an
exercise price per share of $1.20, representing a discount of $1.47 to the last reported
sale price of our ordinary shares on The Nasdaq National Market on the date of grant.
One-third of the options become exercisable on each of the first three anniversaries of
the date of grant. Mr. Margalit also receives the use of an automobile from us and 25 days
of paid vacation per year, as well as other benefits commonly paid by companies in Israel.


Dany Margalit.Effective
  January 2004, the annual base salary of Dany Margalit, our Executive Vice President,
  Technologies and a director, was $144,402. In December 2003, we granted to Mr.
  Margalit options to purchase 65,000 of our ordinary shares at an exercise price
  per share of $8.52 representing the last reported sale price of our
-35-
ordinary shares on The Nasdaq
  National Market on the date of grant. One quarter of the options become exercisable
  on each of the first four anniversaries of the date of grant.


C. BOARD PRACTICES


Board of directors and
executive officers


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


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


External and independent
directors


The
boards of directors of Israeli companies whose shares are publicly traded are required to
include at least two members who qualify as external directors under Israeli law. External
directors must be elected by the vote of a majority of the shares present and voting at a
shareholders meeting provided that either:



    such majority includes at least one-third of the shares
      held by all non-controlling shareholders present and voting at such meeting;
      or
    the total
      number of shares voted against the election of the external director and
      held by shareholders other than controlling shareholders must not exceed
      1% of the aggregate voting rights in the company.External
directors are elected to serve an initial term of three years and may be reelected to
serve in that capacity for one additional term of three years. External directors may be
removed from office by the same percentage of shareholders required for their election or
by a court, in each case, only under limited circumstances, including ceasing to meet the
statutory qualifications for their appointment or violating the duty of loyalty to the
company. If all directors are of the same gender, the next new external director elected
must be of the other gender. Each committee of the board of directors must include at
least one external director, except that the audit committee must include all external
directors then serving. Israeli law regulating the compensation of external directors
prohibits external directors from receiving, directly or indirectly, any compensation,
other than for services as an external director pursuant to the provisions and limitations
set forth in the regulations promulgated under the Israeli Companies Law.


Israeli
law provides that a person is not qualified to serve as an external director if at any
time during the two years preceding his or her appointment, that person, a relative,
partner or employer of that person, or any entity under that persons control has had
any affiliation or business relationship with the company, any entity controlling the
company or an entity that, as of the date of appointment, or at any time during the two
years preceding that date, is controlled by the company or by any entity controlling the
company. In addition, no person may serve as an external director if that persons
professional activities create, or may create, a conflict of interest with that
persons responsibilities as a director or otherwise interfere with that
persons ability to serve as a director. Until the lapse of two years after
termination of membership on the board, we may not engage an external director to serve as
an executive officer or director and cannot employ or retain that person to provide paid
professional services, whether directly or indirectly.


-36-
Dr. Orna Berry was appointed
  as an external director on December 31, 2001 for an initial three-year term
  and was reappointed for a second three year term ending December 31, 2007. On
  December 16, 2003, our shareholders reappointed Dr. Menahem Gutterman as an
  external director for a second three-year term that expires on December 31,
  2006.


In
addition to the requirements of the Israeli law, we comply with The Nasdaq National Market
listing requirements, pursuant to which our board of directors must have at least three
independent directors (including all members of our audit committee) as defined in those
rules. We believe that each member of our audit committee currently satisfies this
requirement. Commencing on July 31, 2005, a majority of the members of our board of
directors (including all members of our audit committee) will be required to be
independent under enhanced independence rules of The Nasdaq National Market.


Audit committee


The
board of directors of an Israeli public company must appoint an audit committee comprised
of at least three directors, including all of the external directors. The chairman of the
board, any controlling shareholder, any relative of a controlling shareholder, and any
director employed by the company or who provides services to the company on a regular
basis (other than as a board member) may not serve on the audit committee. Under The
Nasdaq National Market listing requirements, we are required to have an audit committee
consisting of independent directors who are financially literate and one of whom has
accounting or related financial management expertise. Currently, the members of our audit
committee are Mr. Assia, Dr. Gutterman and Dr. Berry. The rules of the Securities and
Exchange Commission require us to disclose whether one or more members of our audit
committee is a financial expert. We believe that Mr. Assia qualifies as a financial expert
under the SEC rules. Commencing on July 31, 2005, the members of our audit committee
will be required to meet more stringent independence requirements under The Nasdaq
National Market rules, including minimum standards set forth in rules of the Securities
and Exchange Commission and adopted by The Nasdaq National Market. We believe each of Mr.
Assia, Dr. Gutterman and Dr. Berry meet the more stringent independence requirements.


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


Internal auditor


The
board of directors of an Israeli public company must appoint an internal auditor nominated
by the audit committee. An internal auditor may not be:



a
person (or a relative of a person) who holds more than 5% of the company's shares;
a
person (or a relative of a person) who has the power to appoint a director or the general
manager of the company; or
an
executive officer, director or other affiliate; or a member of the company's independent
accounting firm.The
role of the internal auditor is to examine, among other things, the compliance of the
companys conduct with applicable law and orderly business procedures. Mr. Doron
Ruppin serves as our internal auditor.


Compensation and
nominating committees


Our compensation and nominating
  committees each consist of our independent directors, Mr. Assia, Dr. Gutterman
  and Dr. Berry. In January 2005, in accordance with the corporate governance
  rules of The Nasdaq National Market, our compensation and nominating committees
  adopted charters, which set forth each committees responsibilities. Pursuant
  to the charters, the compensation and nominating committees are authorized to
  make decisions regarding
-37-
executive compensation and
  terms and conditions of employment, as well as to recommend that the board of
  directors issue options under our stock option plans. The compensation and nominating
  committees are also responsible for recommending to the board of directors nominees
  for board membership. The charters require that the composition of the committees
  must satisfy The Nasdaq National Markets independent director requirements.


D. EMPLOYEES


As of
December 31, 2004, we and our subsidiaries had 376 employees of whom 216 were based
in Israel, 96 in Europe, 56 in the United States and eight in Japan and Asia.


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



As of December 31,Activity
     2002
     2003
     2004Manufacturing
     53
     53
     61Research and development
     157
     151
     153Marketing and sales
     70
     77
     86Administration and management
     74
     70
     76Total
     354
     351
     376Certain
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 legal minimums. In addition to salary and other
benefits, certain of our sales personnel are paid commissions based on our performance in
certain territories worldwide. In certain European countries, restrictive labor laws can
inhibit our ability to terminate the employment of certain of our subsidiaries
employees.



E. SHARE OWNERSHIP


All of the persons listed
  above, under the caption Directors, 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 27, 2005, Jacob (Yanki) Margalit beneficially held 1,827,461 ordinary
  shares which represented 12.7% of our issued and outstanding share capital,
  and Dany Margalit held 875,445 ordinary shares which is 6.1% of our issued and
  outstanding capital. Information regarding our share option plans presented
  in Note 14D to our consolidated financial statements is incorporated herein
  by reference.


Item 7. Major
Shareholders and Related Party Transactions


A. MAJOR SHAREHOLDERS


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



each
shareholder known by us to own beneficially more than 5% of our outstanding ordinary
shares;
each
of our directors and executive officers individually; and
all
of our directors and executive officers as a group.We have determined beneficial
  ownership in accordance with the rules of the Securities and Exchange Commission.
  Unless indicated below, to our knowledge, the persons and entities named in
  the table have sole voting and sole
-38-
dispositive power with respect
  to all shares beneficially owned, subject to community property laws where applicable.
  Ordinary shares subject to options that are currently exercisable or exercisable
  within 60 days after the date of this report are deemed outstanding and beneficially
  owned by the person holding the options for the purpose of computing the percentage
  ownership of that person, but are not treated as outstanding for the purpose
  of computing the percentage ownership of any other person. Unless indicated
  below, the address for each listed shareholder is c/o Aladdin Knowledge Systems
  Ltd., 15 Beit Oved Street, Tel Aviv 61110, Israel.


The percentage of shares
  beneficially owned is based on 14,367,662 ordinary shares outstanding as of
  May 27, 2005.

Number of
shares
beneficially
owned
     Percentage
of shares
beneficially
ownedJacob
      (Yanki) Margalit(1)
     1,827,461
     12.7%Dany Margalit(2)
     875,445
     6.1%Juniper Trading Services, Inc.(3)
     2,104,700
     14.6%All directors and executive officers as a group (16 persons)(4)
     2,885,756
     19.7%(1)
    Consists of 1,760,795
      ordinary shares and options to purchase 66,666 ordinary shares.(2)
    Consists of 859,195
      ordinary shares and options to purchase 16,250 ordinary shares.(3)
    Based on a Schedule
      13D filed on September 29, 2000, consists of 2,104,700 ordinary shares. The address of Juniper Trading Services, Inc. is Compass Point Building,
      9 Bermudiana Road, Bermuda.(4)
    Consists of 2,646,240
      ordinary shares and options to purchase 255,766 ordinary shares.The
voting rights of our major shareholders do not differ from the voting rights of other
holders of our ordinary shares.


As of May 27, 2005, there
  were a total of 61 holders of record of our issued and outstanding ordinary
  shares, of which 39 were registered with addresses in the United States. Such
  United States holders were, as of such date, the holders of record of approximately
  81.50% of our issued and outstanding ordinary shares.


B. RELATED PARTY
TRANSACTIONS


DIRECTORS FEES


We pay
directors fees in respect of service by our non-executive directors. See Item 6B
Directors, Senior Management and Employees  Compensation.


AGREEMENTS WITH
DIRECTORS AND OFFICERS


Employment agreements


We maintain
written employment agreements with all of our officers. For compensation information
regarding our officers, see ManagementCompensation.


Indemnification
agreements


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


-39-
Our
directors and officers are currently covered by a directors and officers liability
insurance policy. To date, no claims for liability have been filed under this policy.


Loan agreements


In
2000, we entered into loan agreements with several of our officers pursuant to which we
loaned such officers an aggregate amount of $1,150,000 for the purpose of enabling them to
invest in Tamir Fishman Venture Capital II Ltd. The loans were linked to the Israel
consumer price index and were interest-bearing at a 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 U.S. subsidiary.


C. INTERESTS OF EXPERTS
AND COUNSEL


Not applicable.


Item 8. Financial
  Information


A.      CONSOLIDATED
  STATEMENTS AND OTHER FINANCIAL INFORMATION


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


Legal Proceedings


We and
our subsidiary, Aladdin Knowledge Systems Inc., 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 MicroGuard product, which
is
discontinued, and certain of our software DRM products, infringed a now-expired
patent. By an amended complaint, an affiliate of Rainbow Technologies, the holder
of the patent, was
added as a plaintiff. In April 2005, we reached a settlement with respect to
this
claim
pursuant to which we made a one-time payment of $2 million to the plaintiffs
in exchange
for a full
release of all claims.


We are
not a party to any other material litigation or proceeding and are not aware of any other
material litigation or proceeding, pending or threatened, to which we may become a party.


Dividend policy


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


B.      SIGNIFICANT
  CHANGES


On
March 30, 2005, we completed an underwritten public offering of 2,000,000 ordinary shares
resulting in estimated net proceeds to us, of $39.2 million after deducting the
underwriting discount and estimated offering expenses.


Item 9. The Offer
  and Listing


A.      OFFER
  AND LISTING DETAILS


-40-
On May 27, 2005, the last
  reported sale price of our ordinary shares on The Nasdaq National Market was
  $22.35 per share. The table below sets forth the high and low closing sales
  prices of our ordinary shares, as reported by The Nasdaq National Market during
  the periods indicated:




Annual
    High
    Low2005
      (through May 27, 2005)
    
    
    $
    25.40
    
    $
    19.602004
    
    
    
    32.12
    
    
    8.732003
    
    
    
    10.10
    
    
    2.252002
    
    
    
    3.86
    
    
    0.852001
    
    
    
    5.91
    
    
    2.432000
    
    
    
    44.75
    
    
    3.62QuarterlySecond
      Quarter 2005 (through May 27, 2005)
    
    
    $
    23.72
    
    $
    19.91First Quarter
      2005
    
    
    
    25.40
    
    
    19.60Fourth
      Quarter 2004
    
    
    
    32.12
    
    
    21.57Third Quarter
      2004
    
    
    
    28.75
    
    
    13.00Second
      Quarter 2004
    
    
    
    25.75
    
    
    16.21First Quarter
      2004
    
    
    
    19.80
    
    
    8.73Fourth
      Quarter 2003
    
    
    
    10.10
    
    
    5.81Third Quarter
      2003
    
    
    
    7.98
    
    
    3.75Second
      Quarter 2003
    
    
    
    4.10
    
    
    2.59First Quarter
      2003
    
    
    
    3.38
    
    
    2.25Most
      Recent Six MonthsMay 2005
      (through May 27, 2005)
    
    
    $
    22.35
    
    $
    19.91April 2005
    
    
    
    23.72
    
    
    20.47March 2005
    
    
    
    23.39
    
    
    19.60February
      2005
    
    
    
    23.95
    
    
    20.10January
      2005
    
    
    
    25.40
    
    
    22.50December
      2004
    
    
    
    30.12
    
    
    22.80November
      2004
    
    
    
    32.12
    
    
    25.24


-41-
The following table sets
  forth, for the periods indicated, the high and low closing sales prices of our
  ordinary shares on the Tel Aviv Stock Exchange:
**Annual****High****Low**2005 (through May 27, 2005)
     
     
     NIS 112.40
        
     NIS 85.662004
     137.80
        
     69.47QuarterlySecond Quarter 2005 (through May 27, 2005)
     NIS 103.70
        
     NIS 88.24First Quarter 2005
     112.40
        
     85.66Fourth Quarter 2004
     137.80
        
     99.58Third Quarter 2004
     102.30
        
     69.47**Most Recent Six Months**May 2005 (through May 27, 2005)NIS 98.77NIS 88.24April 2005
     103.70
        
     92.31March 2005
     103.00
        
     85.66February 2005
     110.60
        
     88.29January 2005
     112.40
        
     99.72December 2004
     126.80
        
     99.85November 2004
     137.80
        
     113.20As of May 27, 2005, the exchange
  rate of the NIS to the U.S. dollar was $1=NIS 4.401.


B.      PLAN
  OF DISTRIBUTION


Not applicable.

**C.      MARKETS**

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


D.      SELLING
  SHAREHOLDERS


Not applicable.


**E.      DILUTION******Not applicable.


F.      EXPENSES
  OF THE ISSUE


Not applicable.


Item 10. Additional
  Information


A.      SHARE
  CAPITAL

-42-
Not applicable.

B.

MEMORANDUM
AND ARTICLES OF ASSOCIATIONWe are
subject to the provisions of the Israeli Companies Law  1999 (the Companies
Law). The Companies Law codifies the fiduciary duties that office
holders, including directors and executive officers, owe to a company. An office
holder, 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.


Approval of Related Party
Transactions under Israeli Law


Directors and executive
officers


Fiduciary
duties.Israeli law codifies the fiduciary duties that directors and executive
officers owe to a company. These fiduciary duties consist of a duty of care and a duty of
loyalty. The duty of care requires a director or executive officer to act with the level
of care with which a reasonable director or executive officer in the same position would
have acted under the same circumstances. Under the duty of loyalty, a director or
executive officer is required to act in good faith and in the best interests of the
company.


Personal
interest.Israeli law requires that a director or executive officer promptly disclose
to the board of directors any personal interest that he or she may have and all related
material information known to him or her concerning any existing or proposed transaction
with the company. A personal interest of a person includes an interest in any company in
which the person, his or her relative or any entity in which such person or relative has a
personal interest, is a direct or indirect 5% or greater shareholder, director or general
manager or in which he has the right to appoint at least one director or the general
manager. Board approval is required for the transaction, and no transaction that is
adverse to the companys interest may be approved. Approval by the companys
audit committee and board of directors is required for an extraordinary transaction,
meaning any transaction that is not in the ordinary course of business, not on market
terms or is likely to have a substantial effect on the companys profitability,
assets or liabilities. If a majority of the board of directors has a personal interest in
the transaction, shareholder approval is also required.


Compensation
arrangements.Under the Companies Law, all compensation arrangements for executive
officers who are not directors require approval of our board of directors. Extraordinary
transactions with executive officers who are not directors require additional approvals.
Compensation arrangements with directors require the approval of our audit committee,
board of directors and shareholders, in that order. Transactions relating to exculpation,
insurance or indemnification of (a) executive officers require audit committee
approval and subsequent board approvals and (b) directors require audit committee
approval, board approval and subsequent shareholder approval.


Shareholders


Controlling
shareholders.Under Israeli law, the disclosure requirements regarding personal
interests that apply to directors and executive officers also apply to a controlling
shareholder of a public company. A controlling shareholder is a shareholder who has the
ability to direct the activities of a company, including a shareholder who owns 25% or
more of the voting rights if no other shareholder owns more than 50% of the voting rights.


Required
approval. Extraordinary transactions with a controlling shareholder or in which a
controlling shareholder has a personal interest including a private placement in which a
controlling shareholder has a personal interest, and the terms of compensation or
employment of a controlling shareholder or who is a director, executive officer or
employee, or a relative of such a controlling shareholder, require the approval of the
audit committee, the board of directors and the shareholders of the company, in that
order. This shareholder approval must include the majority of shares voted at the meeting.
In addition, either:
-43-


the
majority must include at least one-third of the shares of disinterested shareholders
voted at the meeting; or

the
total number of shares of disinterested shareholders voted against the transaction must
not exceed one percent of the aggregate voting rights in the company.Approval
of our board of directors and shareholders is required for a private placement or a series
of private placements of securities that represent at least 20% of a companys share
capital or voting power that would increase the relative holding of a five percent
shareholder of ours or that would cause any person to become a five percent shareholder,
any portion of the consideration for which is not cash or securities listed on a
recognized stock exchange, or is not at fair market value. A private placement of less
than 20% of our share capital also requires approval of our board of directors and
shareholders, if shares are issued to one of our directors or chief executive officer, or
to a person who is, or would become by way of such issuance, a controlling shareholder.
For these purposes, a controlling shareholder is any shareholder that has the ability to
direct our actions, including any shareholder holding 25% or more of our voting rights if
no other shareholder owns more than 50% of our voting rights. Two or more shareholders
with a personal interest in the approval of the same transaction are deemed to be one
shareholder.


Shareholders
duty of good faith.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.


Our Articles of
Association


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


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


Our
Articles of Association require that we hold our annual general meeting of shareholders
once every calendar year and in accordance with the timing requirements set forth under
Israeli law, at a time and place determined by the board of directors, upon at least 21
days prior notice to our shareholders. No business may be commenced until a quorum of two
or more shareholders who hold or represent between or among them at least 33 1/3% of the
Companys issued share capital are present in person or by proxy. If within a half
hour from the time appointed for the meeting a quorum is not present, the meeting, shall
be dissolved, but in any other case it shall stand adjourned for one week, 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

-44-
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;

any
merger; and

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


Our
Articles of Association provide that our board of directors may from time to time, at
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


Under the
Israeli Companies Law, an Israeli company may not exculpate a director or officer from
liability for a breach of duty of loyalty. A company may, however, approve an act
performed in breach of the duty of loyalty provided that the director or officer acted in
good faith, neither the act nor its approval harms the company, and the director or
officer discloses the nature of his or her personal interest and all material facts and
documents a reasonable time before discussion of the approval. An Israeli company may
exculpate a director or officer in advance from liability to the company for a breach of
duty of care, but only if a provision authorizing such exculpation is included in its
articles of association and such breach does not relate to a dividend or other
distribution by the company. Our articles of association include such a provision.


An
Israeli company may indemnify a director or officer in respect of certain liabilities
either in advance of an event or following an event provided that a provision authorizing
such indemnification is inserted in its articles of association. Our articles of
association contain such a provision. An undertaking by an Israeli company to indemnify a
director or officer for civil actions by third parties must be limited to foreseeable
liabilities and reasonable amounts or criteria determined by the board of directors. An
Israeli company may insure a director or officer against the following liabilities
incurred for acts performed as a director or officer:




a
breach of duty of care to the company or to a third party;

a
breach of duty of loyalty to the company, provided the director or officer acted in good
faith and had a reasonable basis to believe that the act would not prejudice the
interests of the company; and

a
financial liability imposed upon the director or officer in favor of a third party.-45-
C.

MATERIAL
CONTRACTSIdesia Ltd.


In
April, 2004, we entered into a convertible loan agreement with Idesia Ltd. (formerly known
as 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 Idesia, of which $550,000 has already been transferred to Idesia
as a convertible loan. Such loan will be automatically converted into Series A Preferred
Shares of Idesia, unless Idesia 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 Idesia. 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 Idesia, and shall be
entitled in future events of issuance of shares by Idesia, to issuance of certain
additional Series A Preferred Shares, for no consideration. We intend to execute a
cooperation and technology license agreement with Idesia according to which we will
develop a line of commercial products based on Idesias unique technology and Idesia
shall grant us a license to its technology.


D.

EXCHANGE
CONTROLSUnder
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.

TAXATIONISRAELI TAXATION


The
following is a summary of the current tax structure applicable to companies in Israel,
with special reference to its effect on us. The following also contains a discussion of
certain Israeli government programs from which we may benefit. To the extent that the
discussion is based on new tax legislation that has not been subject to judicial or
administrative interpretation, we cannot assure you that the views expressed in the
discussion will be accepted by the tax authorities in question. The 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


Generally,
Israeli companies are subject to corporate tax on taxable income. The corporate tax rate
was reduced in July 2004, from 36% to 35% for the 2004 tax year, 34% for the 2005 tax
year, 32% for the 2006 tax year and 30% for the 2007 tax year and thereafter. However, the
effective rate of tax of a company that derives income from an Approved
Enterprise (as described below) may be considerably lower.


Law for the Encouragement
of Capital Investments, 1959


The Law
for the Encouragement of Capital Investments, 1959, known as the Investment Law, provides
that capital investment in a production facility (or other eligible assets) may, upon
application to and approval by the Investment Center of the Israeli Ministry of Industry
Trade and Labor be designated as an Approved Enterprise. Each certificate of approval for
an Approved Enterprise relates to a specific investment program in the Approved
Enterprise, delineated both by the financial scope of the investment and by the physical
characteristics of the facility or the asset. An Approved Enterprise is entitled to
certain benefits, including Israeli government cash grants or tax benefits.
-46-
An
Approved Enterprise may elect to forego any entitlement to the grants otherwise available
under the Investment Law and, in lieu of the foregoing, participate in an alternative
benefits program, under which the undistributed income from the Approved Enterprise is
fully exempt from corporate tax for a defined period of time. The period of tax exemption
ranges between two and ten years, depending upon the location within Israel of the
Approved Enterprise and the type of Approved Enterprise. Upon expiration of the exemption
period, the Approved Enterprise would be eligible for the otherwise applicable reduced tax
rates under the Investment Law for the remainder, if any, of the otherwise applicable
benefits period. If a company has more than one Approved Enterprise program or if only a
portion of its capital investments are approved, its effective tax rate is the result of a
weighted combination of the applicable rates. The tax benefits from any certificate of
approval relate only to taxable profits attributable to the specific Approved Enterprise.
Income derived from activity that is not integral to the activity of the enterprise should
not be divided between the different enterprises and would therefore not enjoy tax
benefits.


Income
derived from an Approved Enterprise is generally subject to a tax rate of 25% for a period
of seven years. However, further reductions in tax rates depending on the percentage of
the non-Israeli investment in a companys share capital (conferring rights to
profits, voting and appointment of directors) and the percentage of its combined share and
loan capital owned by non-Israeli residents, would apply. The tax rate is 20% if the
non-Israeli investment level is 49% or more but less than 74%, 15% if the non-Israeli
investment level is 74% or more but less than 90%, and 10% if the non-Israeli investment
level is 90% or more. The lowest level of foreign investment during the year will be used
to determine the relevant tax rate for that year. These tax benefits are granted for a
limited period not exceeding seven years or ten years with respect to a company whose
foreign investment level exceeds 25% from the first year in which the Approved Enterprise
has taxable income after utilizing its net operating losses. The period of benefits may in
no event, however, exceed the lesser of (a) 12 years from the year in which the program
was activated or (b) 14 years from the year of receipt of Approved Enterprise status.


Certain
of our facilities have been granted Approved Enterprise status. We have
elected to participate in the alternative benefits program. Under the terms of our
Approved Enterprise program, our income from that Approved Enterprise will be tax exempt
for a period of two years, commencing with the year in which we first generate taxable
income from the relevant Approved Enterprise, and is subject to a reduced tax rate for an
additional period of up to a total of ten years from when the tax exemption began. We
cannot assure you that the current benefit program will continue to be available or that
we will continue to qualify for its benefits.


A
company that has elected to participate in the alternative benefits program and that
subsequently pays a dividend out of the income derived from the Approved Enterprise during
the tax exemption period will be subject to corporate tax in respect of the amount
distributed (including withholding tax thereon) at the rate that would have been
applicable had the company not elected the alternative benefits program (generally 10% to
25%). The dividend recipient is taxed at the reduced withholding tax rate of 15%,
applicable to dividends from the Approved Enterprises if the dividend is distributed
within 12 years after the benefits period or other rate provided under a treaty. The
withholding tax rate will be 25% after such period or a lower rate as provided by a
relevant treaty. In the case of a company with a foreign investment level (as defined by
the Investment Law) of 25% or more, the 12-year limitation on reduced withholding tax on
dividends does not apply.


The
Investment Law also provides that an Approved Enterprise is entitled to accelerated tax
depreciation on property and equipment included in an approved investment program.


Any
future applications we make to the Investment Center will be reviewed separately, and
decisions as to whether or not to approve such applications will be based, among other
things, on the then prevailing criteria set forth in the Investment Law, on the specific
objectives we set forth in such applications and on certain financial criteria. There can
be no assurance that any such applications will be approved.


The
benefits available to an Approved Enterprise are conditional upon our fulfilling certain
conditions stipulated in the Investment Law and its regulations and the criteria set forth
in the specific certificate of approval. If we were to violate those conditions, in whole
or in part, we would be required to refund the amount of tax benefits, plus an amount
linked to the Israeli consumer price index, interest and penalties. We believe that our
Approved Enterprise operates in substantial compliance with all of these conditions and
criteria.
-47-
Tax Benefits under the
Law for the Encouragement of Industry (Taxes), 1969


According
to the Law for the Encouragement of Industry (Taxes), 1969, an industrial company is a
company resident in Israel, at least 90% of the income of which, exclusive of income from
defense loans, capital gains, interest and dividends, is derived from an industrial
enterprise owned by it. An industrial enterprise is defined as an enterprise whose primary
activity in a given tax year is industrial production activity. We believe that we
currently qualify as an industrial company under this definition.


Under
the law, industrial companies are entitled to the following preferred corporate tax
benefits:




deduction
of purchases of know-how and patents over an eight-year period for tax purposes;

the
option to file a consolidated tax return with related Israeli industrial companies that
satisfy conditions described in          the law; and

accelerated
depreciation rates on equipment and buildings.Our
status as an industrial company is not contingent upon the receipt of prior approval from
any governmental authority. However, entitlement to certain benefits under the law is
conditioned upon receipt of approval from Israeli tax authorities. Also, the Israeli tax
authorities may determine that we do not qualify as an industrial company, which would
entail the loss of the benefits that relate to this status. In addition, we might not
continue to qualify for industrial company status in the future, in which case the
benefits described above might not be available to us in the future.


Taxation Under
Inflationary Conditions


The
Income Tax (Inflationary Adjustments) Law, 1985, was designed to neutralize the erosion of
capital investments in business and to prevent tax benefits resulting from deduction of
inflationary expenses. This law applies a supplementary set of inflationary adjustments to
the normal taxable profits computed under regular historical cost principles.


The
Inflationary Adjustments Law introduced a special tax adjustment for the preservation of
equity, based on changes in the Israeli consumer price index, whereby certain corporate
assets are classified broadly into fixed (inflation-resistant) assets and non-fixed
assets. Where a corporations equity exceeds the depreciated cost of fixed assets, a
tax deduction that takes into account the effect of the annual rate of inflation on such
excess is allowed (up to a ceiling of 70% of taxable income for companies in any single
year, with the unused portion carried forward on a linked basis, without limit). If the
depreciated cost of fixed assets exceeds shareholders equity, then such excess,
multiplied by the annual inflation rate, is added to taxable income.


Under
the Inflationary Adjustments Law, results for tax purposes are measured in real terms, in
accordance with changes in the Israeli consumer price index. We are taxed under this law.
The difference between the change in the Israeli consumer price index and the exchange
rate of Israeli currency in relation to the dollar, may in future periods cause
significant differences between taxable income and the income measured in dollars as
reflected in our consolidated financial statements. In addition, subject to certain
limitations, depreciation of fixed assets and losses carried forward are adjusted for
inflation on the basis of changes in the Israeli consumer price index.


Capital Gains Taxes on
Sales of our Ordinary Shares


Nonresidents
of Israel will be exempt from capital gains tax in relation to the sale of our ordinary
shares for so long as (a) our ordinary shares are listed for trading on a stock
exchange in a jurisdiction with which Israel has a treaty, (b) the capital gains are
not accrued or derived by the nonresident shareholders permanent enterprise in
Israel, (c) the ordinary shares in relation to which the capital gains are accrued or
derived were acquired by the nonresident shareholder after the initial listing of the
ordinary shares on a stock exchange outside of Israel and (d) neither the shareholder
nor the particular capital gain is otherwise subject to certain sections of the Israeli
Income Tax Ordinance.


In
addition, pursuant to the Income Tax Treaty between Israel and the United States (the
Tax Treaty), gains derived from the sale, exchange or disposition of our
ordinary shares by a person who qualifies as a resident of the
-48-
United States within the
        meaning of the Tax Treaty and who is entitled to claim the benefits afforded
          to U.S. residents under the Tax Treaty, referred to as a Treaty U.S. Resident,
          would not be
        subject to Israeli capital gains tax, unless such Treaty U.S. Resident owned,
          directly or indirectly, shares representing 10% or more of the voting power
          of our company at any time
        during the 12-month period preceding such sale, exchange or disposition.

Withholding on Dividends
Paid to Non-Residents of Israel


Non-residents
of Israel are subject to income tax on income derived from sources in Israel. On
distributions of dividends, other than bonus shares (stock dividends), tax at the rate of
25% generally will be withheld, unless a different rate is provided in a treaty between
Israel and the shareholders country of residence. Under the Tax Treaty, the maximum
Israeli withholding tax on dividends paid to a holder of shares who is a Treaty U.S.
Resident is 25%. However, as mentioned above under Law for the Encouragement
of Capital Investments, 1959, dividends of an Israeli company paid out of income
derived from an Approved Enterprise during the benefit period will still be subject to a
reduced tax rate of 15%.


The Tax
Treaty further provides that a 12.5% Israeli withholding tax would apply to dividends paid
to a U.S. corporation owning 10% or more of an Israeli companys voting stock during,
in general, the current and preceding tax years of the Israeli company. The lower 12.5%
rate applies only to dividends from income not derived from an Approved Enterprise in the
applicable period and does not apply if the company has certain amounts of passive income.


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


U.S. TAXATION


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




an
individual citizen or resident of the United States for U.S. federal income tax purposes;

a
corporation (or other entity taxable as a corporation for U.S. federal income
    tax purposes) or a partnership (or other entity taxable as a partnership
    for U.S.
federal income tax purposes) created or organized under the laws of the United
         States or any political subdivision thereof;

an
estate, the income of which is includible in gross income for U.S. federal income tax
purposes regardless of its source; or

a
trust (i) if a U.S. court is able to exercise primary supervision over its administration
and one or more U.S. persons          have the authority to control all of its
substantial decisions or (ii) that has in effect a valid election under applicable
         U.S. Treasury regulations to be treated as a U.S. person.A
non-U.S. holder is a beneficial owner of our ordinary shares that is not a U.S. holder.


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


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


This
discussion is based on current provisions of the Internal Revenue Code of 1986, as amended
(the Code), current and proposed Treasury regulations promulgated under the
Code and administrative and judicial interpretations of the Code, all as currently in
effect and all of which are subject to change, possibly with a
-49-
retroactive effect. This
          discussion does not address all aspects of U.S. federal income taxation
        that may be relevant to any particular U.S. holder based on the U.S.
    holders
            particular circumstances. In particular, this discussion does not
    address all U.S. federal income tax
          consequences to U.S. holders who are broker-dealers or who own, directly,
            indirectly or constructively, 10% or more of our outstanding shares
        (by vote or value), real estate
          investment trusts, grantor trusts, U.S. holders holding the ordinary
        shares as part of a hedging, straddle or conversion transaction, U.S.
    holders whose functional currency is not
          the U.S. dollar, insurance companies, tax-exempt organizations, financial
            institutions, persons who are, or hold the ordinary shares through
        a
        partnership or other pass-through
          entity and persons subject to the alternative minimum tax, who may
    be subject to special rules not discussed below. Additionally, this discussion
        does
            not address the possible
          application of U.S. federal estate or gift taxes or any aspect of state,
            local or non-U.S. tax laws.

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


U.S. Holders of Ordinary
Shares


Taxation of
distributions on ordinary shares


Subject
to the discussion below under Tax Consequences if We are a Passive Foreign
Investment Company, a distribution paid by us with respect to the ordinary shares to
a U.S. holder will be treated as dividend income to the extent that the distribution does
not exceed our current and accumulated earnings and profits, as determined for U.S.
federal income tax purposes. The amountof a distribution with respect to the
ordinary shares will equal the amount of cash and the fair market value of any property
distributed and will also include the amount of any Israeli taxes withheld as described
under Israeli Taxation and Government ProgramsWithholding on Dividends Paid to
Non-Residents of Israel. Subject to the discussion below under Tax
Consequences if We are a Passive Foreign Investment Company, dividends that are
received through the taxable year ending December 31, 2008 by U.S. holders that are
individuals, estates or trusts generally will be taxed at the rate applicable to long-term
capital gains (a maximum rate of 15%), provided that such dividends meet the requirements
of qualified dividend income. Dividends that fail to meet such requirements,
and dividends received by corporate U.S. holders, are taxed at ordinary income rates. No
dividend received by a U.S. holder will be a qualified dividend (1) if the U.S.
holder held the ordinary share with respect to which the dividend was paid for less than
61 days during the 121-day period beginning on the date that is 60 days before
the ex-dividend date with respect to such dividend, excluding for this purpose, under the
rules of Code section 246(c), any period during which the U.S. holder has an option to
sell, is under a contractual obligation to sell, has made and not closed a short sale of,
is the grantor of a deep-in-the-money or otherwise nonqualified option to buy, or has
otherwise diminished its risk of loss by holding other positions with respect to, such
ordinary share (or substantially identical securities); or (2) to the extent that the U.S.
holder is under an obligation (pursuant to a short sale or otherwise) to make related
payments with respect to positions in property substantially similar or related to the
ordinary share with respect to which the dividend is paid. If we were to be a
passive foreign investment company (as such term is defined in the Code) for
any year, dividends paid on our ordinary shares in such year or in the following year
would not be qualified dividends. In addition, a non-corporate U.S. holder will be able to
take a qualified dividend into account in determining its deductible investment interest
(which is generally limited to its net investment income) only if it elects to do so; in
such case the dividend will be taxed at ordinary income rates.


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


Dividends paid by us in NIS
  will be included in the gross income of U.S. holders at the dollar amount of
  the dividend (including any Israeli taxes withheld therefrom), based upon the
  spot rate of exchange in effect on the date the distribution is included in
  income. U.S. holders will have a tax basis in the NIS for U.S. federal income
  tax purposes equal to that dollar value. Any subsequent gain or loss in respect
  of the NIS arising from exchange rate fluctuations will generally be taxable
  as U.S. source ordinary income or loss.
-50-
Subject
to the limitations set forth in the Code and the Treasury regulations thereunder,
    U.S. holders may elect to claim as a foreign tax credit against their U.S.
    federal income tax
liability the Israeli income tax withheld from dividends received in respect
    of the ordinary shares. The limitations on claiming a foreign tax credit
    include, among others,
computation rules under which foreign tax credits allowable with respect to specific
classes of income cannot exceed the U.S. federal income taxes otherwise payable
    with respect to each such class of income. In this regard, dividends paid
    by us will be foreign
source passive income for U.S. foreign tax credit purposes or, in
the case of
a financial services entity, financial services income (and, for
two years
beginning after December 31, 2006, as general category income).
U.S. holders that do not elect to claim a foreign tax credit may instead claim
a deduction for
the Israeli income tax withheld if they itemize deductions. The rules relating
to foreign tax credits are complex, and you should consult your tax advisor to
determine whether and
to what extent you would be entitled to this credit. A U.S. holder will be denied
a foreign tax credit for Israeli income tax withheld from a dividend received
on the
ordinary shares (i) if the U.S. holder has not held the ordinary shares
for at least
16 days of the 30-day period beginning on the date which is 15 days
before the
ex-dividend date with respect to such dividend or (ii) to the extent the
U.S. holder is under an obligation to make related payments with respect to positions
in substantially
similar or related property. Any days during which a U.S. holder has substantially
diminished its risk of loss on the ordinary shares are not counted toward meeting
the required 16-day holding period. Distributions of current or accumulated earnings
and
profits will be foreign source passive income for U.S. foreign tax credit purposes.


Taxation of the
disposition of ordinary shares


Subject
to the discussion below under Tax Consequences if We are a Passive Foreign
Investment Company, upon the sale, exchange or other disposition of our ordinary
shares, a U.S. holder will recognize capital gain or loss in an amount equal to the
difference between the amount realized on the disposition and the U.S. holders tax
basis in the ordinary shares. The gain or loss recognized on the disposition of the
ordinary shares will be long-term capital gain or loss if the U.S. holder held the
ordinary shares for more than one year at the time of the disposition. Capital gain from
the sale, exchange or other disposition of ordinary shares held for one year or less is
short-term capital gain. Gain or loss recognized by a U.S. holder on a sale, exchange or
other disposition of ordinary shares will be treated as U.S. source income or loss for
U.S. foreign tax credit purposes.


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


Tax consequences if we
are a passive foreign investment company


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


We believe that we were
    not a PFIC for our 2004 taxable year. Our status in the
    current
    and future years will depend on our assets and income in those years. We
have no reason to believe that our assets or income will change in a manner that
    would cause us to be classified as a PFIC. However, since the determination
    of whether we are a
PFIC is based upon such factual matters as the valuation of our assets (which
    may depend upon our market capitalization, which is subject to fluctuation)
    and, in certain cases,
the assets of companies held by us, there can be no assurance-51-
that we will not become a
PFIC. If we were a PFIC, and you are a U.S. holder, you generally would be subject to
imputed interest charges and other disadvantageous tax treatment with respect to any gain
from the sale or exchange of, and certain distributions with respect to, your ordinary
shares (including the denial of the taxation of such distributions and gains at the lower
rates applicable to long-term capital gains as discussed above under Taxation of
Distributions on Ordinary Shares and Taxation of the Disposition of Ordinary
Shares).


If we
were a PFIC, you could make a variety of elections that may alleviate certain tax
consequences referred to above, and one of these elections may be made retroactively if
certain conditions are satisfied. It is expected that the conditions necessary for making
certain of such elections will apply in the case of our ordinary shares. We will notify
U.S. holders in the event we conclude that we will be treated as a PFIC for any taxable
year.


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


Information reporting
and backup withholding


A U.S.
holder generally is subject to information reporting and may be subject to backup
withholding at a rate of 28% for taxable years through 2010 with respect to dividend
payments made within the United States or by a U.S. payor or U.S. middleman and receipt of
the proceeds from the disposition of the ordinary shares. Backup withholding will not
apply with respect to payments made within the United States or by a U.S. payor or U.S.
middleman to exempt recipients, including corporations, or if a U.S. holder provides a
correct taxpayer identification number, certifies that such holder is not subject to
backup withholding or otherwise establishes an exemption. Backup withholding is not an
additional tax. It may be claimed as a credit against the U.S. federal income tax
liability of a U.S. holder or the U.S. holder may be eligible for a refund of any excess
amounts withheld under the backup withholding rules provided, in either case, that the
required information is furnished to the Internal Revenue Service.


Non-U.S. Holders of
Ordinary Shares


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


     Non-U.S.
          holders will not be subject to information reporting or backup withholding with
          respect to the payment of dividends on ordinary shares unless the payment is
          made within the United States or by a U.S. payor or U.S. middleman. Non-U.S.
          holders will be subject to information reporting and backup withholding at a
          rate of 28% for taxable years through 2010 with respect to the payment within
          the United States or by a U.S. payor or U.S. middleman of dividends on the
          ordinary shares unless the holder provides its taxpayer identification number,
          certifies to its foreign status or otherwise establishes an exemption.


     Non-U.S.
          holders will be subject to information reporting and backup withholding at a
          rate of 28% for taxable years through 2010 on the receipt of the proceeds from
          the disposition of the ordinary shares to, or through, the United States office
          of a broker, whether domestic or foreign, unless the holder provides a taxpayer
          identification number, certifies to its foreign status or otherwise establishes
          an exemption. Non-U.S. holders will not be subject to information reporting or
          backup withholding with respect to the receipt of proceeds from the disposition
          of the ordinary shares by a foreign office of a broker; provided, however, that
          if the broker is a U.S. person or a U.S. related person, information
          reporting (but not backup withholding) will apply unless the broker has
          documentary evidence in its records of the non-U.S. holders foreign status
          or the non-U.S. holder certifies to its foreign status under penalties of
          perjury or otherwise establishes an exemption. For this purpose, a U.S.
          related person is a
-52-
broker or other intermediary
                 that maintains one or more enumerated U.S. relationships. Backup withholding
                 is not an additional tax
                    and may be claimed as a credit against the U.S. federal income tax
                 liability of a non-U.S. holder, or alternatively, the non-U.S. holder
                 may be eligible for a
                    refund of any excess amounts withheld under the backup withholding
                 rules, in either case, provided that the required information is furnished
                 to the Internal
                    Revenue Service.
     
F.

DIVIDENDS
AND PAYING AGENTSNot applicable.


G.

STATEMENTS
BY EXPERTSNot applicable.


H.

DOCUMENTS
ON DISPLAYWe 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
INFORMATIONNot applicable.


Item 11. Quantitative
and Qualitative Disclosures About Market Risk


Market
risk is the risk of losses related to changes in market prices and foreign exchange rates,
that may adversely impact our consolidated financial position, results of operations or
cash flows.
-53-
Foreign exchange risk


Although
we report our consolidated financial statements in U.S. dollars, in 2004 a portion of our
revenues and expenses was denominated, in other currencies. We derived approximately 47%
of revenues in U.S. dollars, 33% in Euros, 13% in Japanese Yen and 7% in British pounds.
In 2004, 73% of our expenses was denominated in U.S. dollars, 17% in Euros, 4% in Japanese
Yen and 6% in British pounds.


Exchange
differences upon translation from the functional currency of our German subsidiary, which
is the Euro, to U.S. dollars are accumulated as a separate component of accumulated other
comprehensive income under shareholders equity. As of December 31, 2004,
accumulated other comprehensive income decreased by $85,000 as compared to
December 31, 2003. As of December 31, 2003, accumulated other comprehensive
income increased by $1.2 million as compared to December 31, 2002. Exchange differences
upon translation from the functional currency from our other selling and marketing
subsidiaries (other than our U.S. subsidiary) to U.S. dollars are reflected in our income
statement under financial income (expenses), net.


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




Year ended December 31,2002
     2003
     2004Actual
     At 2001
exchange
rates(1)
     Actual
     At 2002
exchange
rates(1)
     Actual
     At 2003
exchange
rates(1)(In thousands)Revenues
     
     
     $49,520
        
     $49,192
        
     $54,725
        
     $52,232
        
     $69,121
        
     $65,796Gross profit
     39,282
        
     39,028
        
     44,926
        
     42,001
        
     55,340
        
     52,125Income (loss) from operations
     (2,200
        )
     (2,051
        )
     2,410
        
     1,675
        
     9,830
        
     8,096(1) Based on average
exchange rates during the period.


We have
entered into foreign currency forward contracts and forward exchange options generally of
less than one year duration to hedge a portion of our foreign currency risk on sales
transactions and on non-U.S. dollar monetary items. The objective of these transactions is
to hedge cash flow in U.S. dollars and non-U.S. dollar monetary items against fluctuations
in the exchange rates of the Euro, British pound and the Japanese Yen. As of
December 31, 2004, we held four Euro forward exchange options with nominal amounts of
5 million Euro.


Equity investments


We hold
equity investments in two companies whose securities are traded on the Tel Aviv Stock
Exchange, Tamir Fishman Venture Capital II Ltd. and Comsec Information Security Ltd.
As of December 31, 2004, the combined fair market value of these investments was $1.6
million. The value of these holdings has fluctuated and the fair market value at
December 31, 2003 was $1.2 million.


As of
December 31, 2004, we had invested approximately $6.3 million in two related
private
investment funds managed by Tamir Fishman Ventures Management II Ltd. Each
of these funds invests primarily in the securities of privately-held technology
companies in
Israel. In 2002, we realized an impairment charge of $1.0 million related to
these investments and we may realize additional impairment charges in the future.
We have
committed to invest an additional $2.2 million in these entities prior to 2007.
In March
2005, a fund managed by Tamir Fishman Ventures Management II Ltd.
-54-
concluded the sale of two
          of its portfolio companies. We have been advised that we will receive a distribution
          of approximately $3
        million (of which approximately $970,000 will be in cash and the remainder
          in Class A Common Stock of Agere Systems, Inc.) as a result of these transactions. Approximately 15 percent of the distribution will be held in escrow for
approximately one year to cover potential obligations of the portfolio companies
to the buyers.

Interest rate risk


Our
investments consist primarily of cash and cash equivalents, consisting of short-term bank
deposits with maturities of up to three months. Commencing in October 2004, we invested in
U.S. government securities with maturities of up to four years. It is our policy to hold
such investments to maturity in order to limit our exposure to interest rate fluctuations.
Due to the short and medium-term maturities of these investments, their carrying value
equals the fair value.


Item 12. Descriptions of
Securities Other than Equity Securities


Not Applicable


PART II


Item 13. Defaults,
Dividend Arrearages and Delinquencies


None.


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


None.


Item 15. Controls and
Procedures


Our
chief executive officer and chief financial officer, after evaluating the effectiveness of
our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities
Exchange Act of 1934, as amended) as of December 31, 2004, have concluded that, as of
such date, our disclosure controls and procedures were effective to ensure that
information required to be disclosed by us in reports that we file or submit under the
Exchange Act is accumulated and communicated to our management, including our chief
executive officer and chief financial officer, to allow timely decisions regarding
required disclosure and is recorded, processed, summarized and reported within the periods
specified by the SECs rules and forms.


There
were no changes in our internal controls over financial reporting identified with the
evaluation thereof that occurred during the period covered by this annual report that have
materially affected, or are reasonably likely to materially affect, our internal control
over financial reporting.


Item 16A.

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


Item 16B.

Code of EthicsWe 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 ServicesThe
following table presents fees for professional audit services rendered by Ernst &
Young LLP for the audit of our consolidated annual financial statements for
the years ended December 31, 2004 and 2003, and fees billed for other services
rendered by Ernst & Young LLP.


-55-
2004
     2003Audit Fees(1)
     
     
     $189,276
        
     $117,663Audit-Related Fees(2)
     $22,122
        
     $57,749Tax Fees(3)
     $98,242
        
     $153,522Other Fees(4)
     $15,000
        
     $
    —(1)     
          Audit fees consist of fees for professional services rendered for the
              audit of our consolidated financial statements and services normally
          provided by the independent auditor in connection with statutory and
              regulatory
          filings or engagements.

     
     (2)     
          Audit-related fees are fees principally for services that traditionally
              are performed by the independent auditor, including: review of
              financial statements
          included in our quarterly reports, accounting consultation and
          consultation concerning financial accounting and reporting standards.

     
     (3)     
          Tax services fees consist of compliance fees for the preparation of
          original and amended tax returns, claims for refunds and tax payment-planning
          services for tax compliance, tax planning and tax advice. Tax service fees also
          include fees relating to other tax advices, tax consulting and planning other
          than for tax compliance and preparation.


(4)     Other
fees consist of fees relating to the secondary offering.


Our Audit Committee has
    adopted a policy for pre-approval of audit and non-audit services. Under
    the policy,
    the Audit Committee Proposed services either may be
pre-approved without consideration of specific case-by-case services by the Audit
Committee (general pre-approval) or they may require the specific
pre-approval
of the Audit Committee (specific pre-approval). The Audit Committee
employs a combination of these two approaches. Unless a type of service has received
general
pre-approval, it will require specific pre-approval by the Audit Committee if
it is to be provided by the independent auditor. The term of any general pre-approval
is 12 months
from the date of pre-approval, unless the Audit Committee considers a different
period and states otherwise. The Audit Committee reviews annually and pre-approves
the services that
may be provided by the independent auditor without obtaining specific pre-approval
from the Audit Committee. The Audit Committee adds to or subtracts from the list
of general
pre-approved services from time to time, based on subsequent determinations.


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


Item 16D.

Exemptions for the Listing Standards for Audit CommitteesNot applicable.


Item 16E.

Purchase of Equity Securities by the Issuer and Affiliated PurchasersNot applicable.


PART III


Item 17. Financial
Statements


Not applicable


Item 18. Financial Statements


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


Item 19. Exhibits


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



1.1

Articles
of Association, as amended, dated February 6, 2005(1)-56-
1.3

Memorandum
of Association of the registrant.(2)(3)4.1

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

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

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

Form
of Indemnification Agreement between the registrant and each of the members of its board
of directors and its officers.(6)4.5

Convertible
Loan Agreement dated as of April 29, 2004, by and between C-Signature Ltd. and the
registrant. (5)(6)8

List
of subsidiaries.*10.1

Consent
letter from Kost, Forer, Gabbay & Kasierer.*10.2

Consent
letter from Blick Rothenberg.*11.

Code
of Ethics(6)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.**Filed herewith.


     (1)
          Incorporated by reference from our Registration Statement on Form F-3, File
          No. 333-121361, as amended, filed with the Commission on March 8, 2005.


     (2)
          Incorporated by reference from our Registration Statement on Form F-1 File
          No. 33-67980, as amended, filed with the Commission on August 26, 1993.


     (3)
          English translation or summary from Hebrew original.


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


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


     (6)
          Incorporated by reference from our 2003 annual report on Form 20-F filed with
          the Commission on June 30, 2004.

-57-
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 31st day of May 2005.


ALADDIN KNOWLEDGE
SYSTEMS LTD.


By: /s/ Jacob
      (Yanki) MargalitJacob (Yanki) Margalit
Chief Executive Officer and
Chairman of the Board-58-
Aladdin Knowledge Systems Ltd. and Subsidiaries

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PageReport of Independent Public Accounting Firm


F-2Report of Independent Auditors


F-3Consolidated Balance Sheets


F-4Consolidated Statements of Operations


F-6Statements of Changes in Shareholders' Equity


F-7Consolidated Statements of Cash Flows


F-8Notes to Consolidated Financial Statements


F-10
F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTING FIRMTo 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, 2003 and 2004, 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, 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements, based on our audits. We did not audit the financial statements of Aladdin Western Europe Ltd., a wholly-owned U.K. subsidiary, which statements reflect total assets constituting 4% in 2003 and 2% in 2004, and total revenues constituting 7% in 2002, 15% in 2003 and 16% in 2004 of the related consolidated totals. Those statements were audited by other
auditors whose report has been furnished to us, and our opinion, insofar as it relates to the data included for Aladdin Western Europe Ltd., is based solely on the report of the other auditors.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company and its subsidiaries as of December 31, 2003 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
Tel-Aviv, Israel
March 8, 2005

/s/ KOST FORER GABBAY & KASIERER
A Member of Ernst & Young Global
F-2
REPORT OF INDEPENDENT AUDITORSTo 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, 2003 and 2004, and the related statements of operations and changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements, based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2003 and 2004 and the results of their operations and cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
/s/ BLICK ROTHENBERG
BLICK ROTHENBERG
Chartered Accountants
Registered Auditors
March 8, 2005

12 York Gate
Regent's Park
London
NW1 4QS
F-3
Aladdin Knowledge Systems Ltd. and Its SubsidiariesCONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands)
December 31,2003

2004ASSETSCURRENT ASSETS:Cash and cash equivalents

$
18,287


$
17,313Marketable securities (Note 3)


1,229



8,598Trade receivables (net of allowance for doubtful accounts—$972 in 2003 and $995 in 2004)


9,766



12,637Other accounts receivable and prepaid expenses (Note 4)


2,223



3,661Deferred income taxes (Note 12)


669



657Inventories (Note 5)


5,795



5,788Total current assets


37,969



48,654LONG-TERM INVESTMENTS:Investment in other companies (Note 6)


3,962



6,338Severance pay fund


2,322



2,357Total long-term investments


6,284



8,695PROPERTY AND EQUIPMENT, NET (Note 7)


2,447



2,234OTHER ASSETS, NETIntangible assets, net (Note 8)


531



2,553Goodwill (Note 9)


7,281



7,685Deferred income taxes (Note 12)


956



1,073Total other assets


8,768



11,311Total assets

$
55,468


$
70,894The accompanying notes are an integral part of the consolidated financial statements.
F-4
Aladdin Knowledge Systems Ltd. and Its SubsidiariesCONSOLIDATED BALANCE SHEETS
(U.S. dollars in thousands, except share data)
December 31,2003

2004LIABILITIES AND SHAREHOLDERS' EQUITYCURRENT LIABILITIES:Trade payables

$
2,306


$
3,546Deferred revenues


3,415



4,793Accrued expenses and other accounts payable (Note 10)


5,623



5,989Total current liabilities


11,344



14,328ACCRUED SEVERANCE PAY


3,168



3,129COMMITMENTS AND CONTINGENT LIABILITIES (Note 11)SHAREHOLDERS' EQUITY (Note 13):Share capital: Ordinary shares of NIS 0.01 par value—Authorized: 15,000,000 shares at December 31, 2003 and 2004; Issued: 11,477,922 and 12,345,536 shares at December 31, 2003 and 2004, respectively; Outstanding: 11,405,302 and 12,345,536 shares at December 31, 2003 and 2004, respectively


37



39Additional paid-in capital


36,147



39,696Treasury shares


(377
)


—Deferred stock compensation


—



(66
)Accumulated other comprehensive loss


(3,092
)


(3,189
)Retained earnings


8,241



16,957Total shareholders' equity


40,956



53,437Total liabilities and shareholders' equity

$
55,468


$
70,894The accompanying notes are an integral part of the consolidated financial statements.
F-5
Aladdin Knowledge Systems Ltd. and Its SubsidiariesCONSOLIDATED STATEMENTS OF OPERATIONS
(U.S. dollars in thousands, except per share data)
Year ended December 31,2002

2003

2004Revenues (Note 14):Software security

$
40,093


$
43,521


$
50,650Enterprise security


9,427



11,204



18,471Total revenues


49,520



54,725



69,121Cost of revenues:Software security


8,405



7,995



9,541Enterprise security


1,833



1,804



4,240Total cost of revenues


10,238



9,799



13,781Gross profit


39,282



44,926



55,340Operating expenses:Research and development


12,245



12,759



12,028Selling and marketing


21,990



22,012



24,677General and administrative


7,247



7,745



8,805Total operating expenses


41,482



42,516



45,510Operating income (loss)


(2,200
)


2,410



9,830Financial income, net (Note 15a)


491



480



53Other expenses, net (Note 15b)


(932
)


(5
)


(138
)Income (loss) before taxes on income


(2,641
)


2,885



9,745Taxes on income (Note 12)


2,738



49



957Income (loss) before equity in losses of an affiliate


(5,379
)


2,836



8,788Equity in losses of an affiliate


(1,257
)


(100
)


—Net income (loss)

$
(6,636
)

$
2,736


$
8,788Net earnings (loss) per share (Note 15c):Basic

$
(0.59
)

$
0.24


$
0.74Diluted

$
(0.59
)

$
0.23


$
0.68The accompanying notes are an integral part of the consolidated financial statements.
F-6
Aladdin Knowledge Systems Ltd. and its SubsidiariesSTATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(U.S. dollars in thousands)
Share
capital

Additional
paid-in
capital

Treasury
shares

Deferred
stock
compensation

Accumulated
other
comprehensive
loss

Retained
earnings

Total
comprehensive
income (loss)

Total
shareholders'
equityBalance as of January 1, 2002

$
37


$
36,147


$
(1,164
)

$
—


$
(4,863
)

$
12,472


$
—


$
42,629Other comprehensive loss:Unrealized losses on available-for-sale marketable securities, net of taxes


—



—



—



—



(645
)


—



(645
)


(645
)Less—reclassification of adjustment of other than temporary decrease in value of available-for-sale marketable securities


—



—



—



—



250



—



250



250Foreign currency translation adjustments


—



—



—



—



729



—



729



729Total other comprehensive income


—



—



—



—



—



—



334



—Net loss


—



—



—



—



—



(6,636
)


(6,636
)


(6,636
)Total comprehensive loss

























$
(6,302
)Balance as of December 31, 2002


37



36,147



(1,164
)


—



(4,529
)


5,836


$
—



36,327Exercise of stock options


—



—



787



—



—



(331
)


—



456Other comprehensive income:Unrealized gain on available-for-sale marketable securities, net of taxes


—



—



—



—



260



—



260



260Foreign currency translation adjustments


—



—



—



—



1,177



—



1,177



1,177Total other comprehensive income


—



—



—



—



—



—



1,437



—Net income


—



—



—



—



—



2,736



2,736



2,736Total comprehensive income

























$
4,173Balance as of December 31, 2003


37



36,147



(377
)


—



(3,092
)


8,241


$
—



40,956Exercise of stock options


2



3,335



377



—



—



(72
)


—



3,642Deferred stock compensation


—



214



—



(214
)


—



—



—



—Amortization of deferred stock compensation


—



—



—



148



—



—



—



148Other comprehensive income:Unrealized gain on available-for-sale marketable securities, net of taxes


















223







223



223Foreign currency translation adjustments


















85







85



85Unrealized losses from hedging transactions


















(405
)






(405
)


(405
)Total other comprehensive income


























(97
)


—Net income


—



—



—



—



—



8,788



8,788



8,788Total comprehensive income

























$
8,691Balance as of December 31, 2004

$
39


$
39,696


$
—


$
(66
)

$
(3,189
)*

$
16,957






$
53,437*

Composed as follows:Accumulated unrealized gains from available-for-sale marketable securities, net of taxes

$
416Accumulated unrealized losses from hedging transactions


(405
)Accumulated foreign currency translation adjustments


(3,200
)Accumulated other comprehensive loss

$
(3,189
)The accompanying notes are an integral part of the consolidated financial statements.
F-7
Aladdin Knowledge Systems Ltd. and its SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)
Year ended December 31,2002

2003

2004Cash flows from operating activities:Net income (loss)

$
(6,636
)

$
2,736


$
8,788Adjustments required to reconcile net income (loss) to net cash provided by operating activities:Depreciation and amortization


2,310



2,110



2,072Equity in losses of an affiliate


1,257



100



—Impairment of investment in other company


1,038



—



—Increase (decrease) in accrued severance pay, net


28



31



(74
)Impairment of available-for-sale marketable securities


391



—



—Amortization of deferred stock compensation


—



—



148Deferred income taxes, net


2,500



(414
)


(81
)Decrease (increase) in trade receivables


109



(1,450
)


(2,515
)Decrease in inventories


1,383



1,033



198Decrease (increase) in other accounts receivable and prepaid expenses


984



72



(1,315
)Increase (decrease) in trade payables


304



(114
)


1,160Increase in deferred revenues


297



1,092



1,378Increase (decrease) in accrued expenses and other accounts payable


317



723



(997
)Other


(35
)


(15
)


(7
)Net cash provided by operating activities


4,247



5,904



8,755Cash flows from investing activities:Investment in available-for-sale marketable securities


—



—



(7,000
)Investment in shares and long-term loan of an affiliate


(987
)


(100
)


—Purchase of property and equipment


(1,141
)


(913
)


(1,237
)Proceeds from sale of property and equipment


74



139



15Purchase of intangible assets


(16
)


—



(1,220
)Investment in other companies


(444
)


(1,710
)


(2,376
)Payment for the purchase of Aladdin Knowledge España, S.L.,(1)


—



—



(1,791
)Net cash used in investing activities


(2,514
)


(2,584
)


(13,609
)The accompanying notes are an integral part of the consolidated financial statements.
F-8
Aladdin Knowledge Systems Ltd. and its SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWS
(U.S. dollars in thousands)
Year ended December 31,2002

2003

2004Cash flows from financing activities:Proceeds from exercise of options


—



456



3,642Net cash provided by financing activities


—



456



3,642Effect of exchange rate on cash and cash equivalents


296



276



238Increase (decrease) in cash and cash equivalents


2,029



4,052



(974
)Cash and cash equivalents at the beginning of the year


12,206



14,235



18,287Cash and cash equivalents at the end of the year

$
14,235


$
18,287


$
17,313Supplemental disclosure:Income taxes paid during the year

$
419


$
490


$
698Non-cash activities:Investment in intangible assets

$
—


$
—


$
260Waiver of employee loans in exchange for investment in Tamir Fishman Venture II Ltd.

$
600


$
—


$
—Conversion of balance in trade receivable due from an affiliate to long-term loan to an affiliate

$
244


$
—


$
—(1)Payment for purchase of Aladdin KnowledgeEspaña, S.L. (see Note 18b):Fair value of assets acquired and liabilitiesassumed at the date of acquisition:Working capital net (excluding cash andcash equivalents in the amount of $188)









$
223Property and equipment










13Customer list










1,151Goodwill










404$
1,791The accompanying notes are an integral part of the consolidated financial statements.
F-9
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
1.   General
a.

Aladdin Knowledge Systems Ltd. and its wholly-owned subsidiaries (collectively, the “Company” or “Aladdin”) is a global provider of security solutions that reduce software theft, authenticate network users and protect against unwanted Internet and e-mail content, including spam and viruses. The Company's security products are organized into two segments: software digital rights management, or DRM, and enterprise security.The Company's software DRM products allow software publishers to manage licensing and distribution of their software while limiting revenue loss from software theft and piracy. The HASP products include: HASP HL and HASP NET, hardware-based software security systems and Privilege SCP, which has been rebranded HASP SL, a software marketing, licensing and distribution platformWithin enterprise security, Aladdin develops and markets the USB-based eToken hardware device for user authentication and the eSafe line of content security solutions that protect PCs and networks against viruses, worms, spam and non-productive Internet-borne contentThe Company is dependent upon sole source suppliers for certain key components used in its products. Although there is a limited number of manufacturers of these particular components, the Company's management believes that other suppliers could provide similar components at comparable terms. A change in suppliers, however, could cause a delay in manufacturing and a possible loss of sales, which could adversely effect the operating results of the Company and its financial position.b.

Acquisition of Aladdin Knowledge España, S.L.:On July 16, 2004, the Company entered into a Share Purchase Agreement with the shareholders of its former distributor, Aladdin Knowledge Systems España, S.L (“Aladdin España”), in order to enhance the service provided to Spanish-speaking countries. Pursuant to the agreement, the Company acquired 100% of Aladdin España's shares, and thereafter it became a wholly-owned subsidiary of the Company.The total consideration for the purchase of the shares was $1,979 (including approximately $136 of acquisition costs) out of which an amount of $107 was deposited in an escrow account for a period of three years to cover any claims against the sellers pursuant to their representations and warranties to the Company in the Share Purchase Agreement.Aladdin España is engaged in the marketing, distributing, selling, licensing and support of certain proprietary software products of the Company in Spain. The acquisition has been accounted for using the purchase method of accounting and, accordingly, the purchase price has been allocated to the assets acquired and the liabilities assumed based on the estimated fair value at the date of acquisition. Regarding the allocation of the goodwill, see also Note 9.
F-10
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
1.   General (continued)
Based upon a valuation of tangible and intangible assets acquired, the Company has allocated the total cost of the acquisition, as follows:At July 16, 2004Current assets

$
802Property and equipment


13Intangible assets:Customer list


1,151Goodwill


404Total assets acquired


2,370Liabilities assumed:Current liabilities


391Total liabilities assumed


391Net assets acquired

$
1,979The following represents the unaudited pro-forma results of operations for the years ended December 31, 2003 and 2004 assuming that the Aladdin España acquisition had been consummated as of January 1, 2003 and 2004, respectively. Intercompany transactions prior to acquisition have been eliminated.Year ended
December 312003

2004(unaudited)Revenues

$
55,690


$
69,979Net income

$
2,842


$
9,073Basic net earnings per share

$
0.25


$
0.76Diluted net earnings per share

$
0.24


$
0.70The pro-forma financial information is not necessarily indicative of the consolidated results that would have been attained had the acquisition taken place at the beginning of 2004 or 2003, nor is it necessarily indicative of future results.
c.

Restructuring charges:As a result of the downturn in global economic conditions, the decline in overall business levels and the related impact on the Company's operations, the Company and its subsidiaries implemented during 2002 a worldwide restructuring and cost reduction plan. In connection with the 2002 restructuring plan, Emerging Issues Task Force 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Cost to Exit an Activity (Including Certain Cost in Restructuring)” and Staff Accounting Bulletin No. 100 “Restructuring and Impairment Charges” were applied. The Company and its subsidiaries incurred expenses of $1,123, out of which $467 were included in research and development expenses, $500 in selling and marketing expenses and $156 in general and administrative expenses.
F-11
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
1.   General (continued)
The major components of restructuring charges were as follows:Year ended
December 31, 2002Employee termination benefits

$
603Facilities closures


166Consulting fees


160Other


194$
1,1232.   Significant accounting policies
Basis of presentation
The consolidated financial statements have been prepared according to United States Generally Accepted Accounting Principles (“U.S. GAAP”).
Use of estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.
Financial statements in United States dollars:
1.

The majority of the revenues of the Company and certain of its subsidiaries is generated in United States dollars (“dollar”). In addition, a substantial portion of the Company's and certain of its subsidiaries' costs is incurred in dollars. The Company's management believes that the dollar is the primary currency of the economic environment in which the Company and certain of its subsidiaries operate. Thus, the functional and reporting currency of the Company and certain of its subsidiaries is the dollar. Accordingly, monetary accounts maintained in currencies other than the dollar are remeasured into U.S. dollars in accordance with Statement of Financial Accounting Standard Board No. 52 “Foreign Currency Translation”. All transactions gains and losses of the remeasured monetary balance sheet items are
reflected in the statement of operations as financial income or expenses, as appropriate.2.

The financial statements of a foreign subsidiary whose functional currency is not the U.S. dollar, have been translated into U.S. dollars. All balance sheet accounts have been translated using the exchange rates in effect at the balance sheet date. Statement of operations amounts have been translated using the average exchange rate for the year. The resulting aggregate translation adjustments are reported as a component of accumulated other comprehensive loss in shareholders' equity.Principles of consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany transactions and balances, including profits from intercompany sales not yet realized outside the Group, have been eliminated upon consolidation.
F-12
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
2.   Significant accounting policies (continued)
Cash and cash equivalents
Cash and cash equivalents include short-term, highly liquid investments that are readily convertible to cash with maturities of three months or less at the date acquired.
Marketable securities
Management determines the classification of its investments in marketable securities at the time of purchase and reevaluates such designations as of each balance sheet date. During 2004 and 2003, 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 in each period whether declines in the market value of its 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 15a).
Investment in other companies
The investment in these companies, in which the Company holds less than 20%, is stated at cost, since the Company does not have the ability to exercise significant influence over operating and financial policies of the investees. The Company's investment in the other companies is reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an investment may not be recoverable. During 2002, based on management's most recent analyses, impairment losses were identified in the amount of $1,038 (see Note 6 and Note 15b).
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, and 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:
F-13
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
2.   Significant accounting policies (continued)
%Computers and peripheral equipment


15–33Office furniture and equipment


6–20Motor vehicles


15Leasehold improvements


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


5Customer list


7Domain name


3Patent


13.5Goodwill
Goodwill is measured as the excess of the cost of an acquired company over the sum of the amounts assigned to tangible and identifiable intangible assets acquired less liabilities assumed. Goodwill is not amortized, but rather reviewed for impairment at least annually in accordance with the provisions of SFAS No. 142
The goodwill impairment test under SFAS No. 142 involves a two-step approach. Under the first step, the Company determines the fair value of each reporting unit to which goodwill has been assigned. The reporting units of the Company for purposes of the impairment test are the Company's two operating segments, the software digital rights management, or DRM, and enterprise security, as these are the components of the business for which discrete financial information is available and segment management regularly reviews the operating results of those components. The Company then compares the fair value of each reporting unit to its carrying value, including goodwill. The Company estimates the fair value of each reporting unit by estimating the present value of the reporting unit's future cash flows. If the fair value exceeds the carrying value,
no impairment loss is recognized. If the carrying value exceeds the fair value, the goodwill of the reporting unit is considered potentially impaired and the second step is completed in order to measure the impairment loss.
The Company performs the annual impairment tests during the fourth fiscal quarter. During 2002, 2003 and 2004, no impairment losses were identified.
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”), whenever
F-14
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
2.   Significant accounting policies (continued)
events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the future undiscounted cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. During 2002, 2003 and 2004, no impairment losses were identified.
Income taxes
The Company and its subsidiaries account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). This Statement prescribes the use of the liability method whereby deferred tax assets and liability account balances are determined based on the differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company and its subsidiaries provide a valuation allowance, if necessary, to reduce deferred tax assets to their estimated realizable value.
Research and development costs
Research and development costs are charged to the statement of operations as incurred. Statement of Financial Accounting Standard No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed” (“SFAS No. 86”), requires capitalization of certain software development costs, subsequent to the establishment of technological feasibility.
Based on the Company's product development process, technological feasibility is established upon completion of a working model. Costs incurred by the Company between completion of the working models and the point at which the products are ready for general release have been insignificant. Therefore, all research and development costs have been expensed.
Revenue recognition
The Company derives revenues from sales of its hardware products (HASP HL, HASP NET and eToken) and from licensing the right to use its software products (eSafe and HASP SL) which includes maintenance and support.
The hardware based products contain an insignificant embedded software element which is incidental to the product as a whole since the embedded software is not marketed or sold separately and is used solely in connection with the operation of the hardware products.
The Company generates revenues from the sale of its products directly to end-users and indirectly, mostly through value-added resellers, original equipment manufacturers and independent distributors (all of whom are considered end-users). Other than pricing terms which may differ due to the different volume of purchases between resellers, manufacturers and distributors and end-users, there are no material differences in the terms and arrangements involving direct and indirect customers. All of the Company's products sold through agreements with value-added resellers, original equipment manufacturers and independent distributors are non-exchangeable, non-refundable, nonreturnable and without any rights of price protection or stock rotation. Accordingly, the Company considers them all end-users.
The Company accounts for its software products (eSafe and HASP SL) sales in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” as amended (“SOP No. 97-2”) and for its hardware products (HASP HL, HASP NET and eToken) sales which are separated products in accordance with Staff Accounting Bulletin No. 104 “Revenue Recognition” (“SAB 104”)
F-15
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
2.   Significant accounting policies (continued)
when persuasive evidence of an arrangement exists, delivery has occurred, the vendor's fee is fixed or determinable, no further obligation exists and collectibility is probable. Hardware based products contain an insignificant embedded software element which is incidental to the product as a whole since the embedded software is not marketed or sold separately and is used solely in connection with the operation of the hardware products.
Persuasive evidence of an arrangement exists.The Company determines that persuasive evidence of an arrangement exists with respect to a customer when it has a written contract, which is signed by both the Company and the customer or a purchase order from the customer (documentation is dependent on the business practice for each type of customer).
Delivery has occurred.The Company's hardware and software products may be physically delivered to the customer, or with regard to software products, the products may be electronically delivered to the customer. The Company determines that delivery of hardware products has occurred when the title and risk of loss have been transferred to the customer. In connection with delivery of software products, the Company determines that delivery has occurred upon shipment of the software or, when the software is made available to the customer through electronic delivery, when the customer has been provided with access codes that allow the customer to take immediate possession of the software.
The fee is fixed or determinable.Generally, payments that extend beyond 30 days from the contract date but that are due within six months are deemed to be fixed or determinable based on the Company's successful collection history on such arrangements. Arrangements with payment terms extending beyond these customary payment terms are considered not to be fixed or determinable, and revenue from such arrangements is recognized as payments become due from the customer, provided that all other revenue recognition criteria have been met.
Collectibility is probable.The Company determines whether collectibility is probable on a case-by case basis. When assessing probability of collection, the Company considers the customer's financial condition, the number of years in business with the customer and the history of collection. If the Company determines from the outset that collectibility is not probable based upon its review process, revenue is recognized as payments are received.
With regard to software arrangements involving multiple elements such as software product and maintenance and support, the Company has adopted Statement of Position No. 98-9, “Modification of SOP No. 97-2, Software Revenue Recognition with Respect to Certain Transactions” (“SOP No. 98-9”). According to SOP No. 98-9, revenues should be allocated to the different elements in the arrangement under the “residual method” when Vendor Specific Objective Evidence (“VSOE”) of fair value exists for all undelivered elements and no VSOE exists for the delivered elements. Under the residual method, at the outset of the arrangement with the customer, the Company defers revenue for the fair value of its undelivered elements (maintenance and support) and recognizes revenue for the remainder of the arrangement
fee attributable to the elements initially delivered in the arrangement (software product) when the basic criteria in SOP No. 97-2 have been met. Any discount in the arrangement is allocated to the delivered element. Maintenance and support revenue is deferred and recognized on a straight-line basis over the term of the maintenance and support agreement. The VSOE of fair value of the undelivered elements (maintenance and support) is determined based on the price charged for the undelivered element when sold separately. Time-based licenses include maintenance and on-going support. VSOE of fair value does not exist for the related support arrangement as maintenance is not priced or offered separately for such arrangements. In these cases, the Company recognizes the license and maintenance revenue ratably over the period of each arrangement.
F-16
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
2.   Significant accounting policies (continued)
Deferred revenues include unearned amounts received from maintenance and support contracts and amounts received from customers but not recognized as revenues.
Severance pay
The Company's liability for its Israeli employees' severance pay is calculated pursuant to Israel's Severance Pay Law, based on the most recent salary of the Israeli employees, multiplied by the number of years of employment as of balance sheet date. Employees are entitled to one month's salary for each year of employment, or a portion thereof. The Company's liability for all of its employees in Israel is fully provided by monthly deposits with severance pay funds, insurance policies and by an accrual. The value of those policies is recorded as an asset in the Company's balance sheet.
The deposited funds include profits accumulated up to the balance sheet date. The deposited funds may be withdrawn only upon fulfillment of the obligation pursuant to Israel's Severance Pay Law or labor agreements. The value of the deposited funds is based on the cash surrender value of these policies, and includes immaterial profits.
Severance pay expenses for the years ended December 31, 2002, 2003 and 2004, amounted to $1,468, $1,411 and $1,057, respectively.
Advertising expenses
Advertising expenses are charged to the statement of operations, as incurred. Advertising expenses for the years ended December 31, 2002, 2003 and 2004 were $3,717, $2,773 and $3,488, respectively.
Concentrations of credit risk
Financial instruments that potentially subject the Group to concentrations of credit risk consist principally of cash and cash equivalents, marketable securities and trade receivables.
The majority of the Company's cash and cash equivalents is invested in U.S. dollar deposits with major banks in Israel, the United States, Japan, Germany, the Netherlands, the United Kingdom 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 United States, Europe, Japan and Israel. The Company performs ongoing credit evaluations of its customers and, to date has not experienced any material losses. An allowance for doubtful accounts is determined with respect to those amounts that the Company has determined to be doubtful of collection, on a specific account basis.
The doubtful accounts expenses for the years ended December 31, 2002, 2003 and 2004 were $208, $240 and $194, respectively.
The Company's marketable securities include investments in U.S government securities. Management believes that minimal credit risk exists with respect to these marketable securities.
F-17
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
2.   Significant accounting policies (continued)
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 loss per Ordinary share for the periods ended December 31, 2002, because all such securities were anti-dilutive.
The total weighted average number of shares related to the outstanding excluded from the calculations of diluted net loss per share was 1,543,900, 0 and 0 for the years ended December 31, 2002, 2003 and 2004, respectively
Accounting for stock-based compensation
The Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and FASB Interpretation No. 44 “Accounting for Certain Transactions Involving Stock Compensation”, in accounting for its employee stock option plans. Under APB No. 25, when the exercise price of an employee stock option 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 in 2002, 2003, 2004 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:
Year ended December 31,2002

2003

2004Dividend yield


0%



0%



0%Expected volatility


25.8%



80.2%



75.4%Risk-free interest


1.5%



2.5%



2.8%Expected life of up to


5 years



4.5 years



4.5 years
F-18
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
2.   Significant accounting policies (continued)
Pro forma information under SFAS No. 123:
Year ended December 31,2002

2003

2004Net income (loss) available to Ordinary shares—as reported

$
(6,636
)


2,736



8,788Add: stock based employee compensation intrinsic value


—



—



148Deduct: stock-based employee compensation—fair value


211



542



1,059Pro forma:Net income (loss)

$
(6,847
)

$
2,194


$
7,877Earnings per share:Earnings (loss) as reported

$
(0.59
)

$
0.24


$
0.74Diluted earnings (loss) as reported

$
(0.59
)

$
0.23


$
0.68Pro forma basic earnings (loss)

$
(0.61
)

$
0.19


$
0.66Pro forma diluted earnings (loss)

$
(0.61
)

$
0.18


$
0.61Fair 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:
The Company has instituted a foreign currency cash flow hedging program using put and call options (zero-cost collar) to hedge against the risk of overall changes in cash flows resulting from forecasted foreign currency sales during the year. These option contracts are designated as cash flow hedges, as defined by Financial Accounting Standards Board Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”).
SFAS 133 requires companies to recognize all of its derivative instruments as either assets or liabilities in the statement of financial position at fair value. The accounting for changes in the fair value (i.e., gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship.
For those derivative instruments that are designated and qualify as hedging instruments, 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.
F-19
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
2.   Significant accounting policies (continued)
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 (loss) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item, if any, is recognized in current earnings during the period of change.
All other derivatives which do not qualify for hedge accounting under FAS 133, are recognized on the balance sheet at their fair value, with changes in the fair value carried to the statements of income and included in the financial expenses.
The Company recognized losses from derivative instruments of $437 during the year ended December 31, 2004, out of which an amount of $203 has been deducted from revenues in the statement of operations and amount of $234 has been recorded to financial income, net.
The balance in accumulated other comprehensive income (loss) related to derivative instruments as of December 31, 2004 is expected to be recognized in earnings over next six months.
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:
On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), Share Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock Based Compensation. SFAS 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flow. Generally, the approach adopted by SFAS 123R is similar to the approach described in Statement 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair value. Pro forma disclosure is no longer an alternative.
SFAS 123R must be adopted by no later than July 1, 2005. Early adoption is permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS 123R on July 1, 2005.
SFAS 123R permits companies to adopt its requirement using one of the two methods:
1.

A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123R for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date.2.

A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based in the amounts previously recognized under SFAS 123R for purposes of pro forma disclosures either: (a) all prior periods presented or (b) the prior interim period of the year of adoption.As permitted by SFAS 123, the Company currently accounts for share based payments to employees using APB 25 intrinsic value method and, as such, generally recognizes no compensation cost for
F-20
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
2.   Significant accounting policies (continued)
employee stock options. Accordingly, the adoption of SFAS 123R fair value method will have a significant impact on the Company's results of operations, although it will have no impact on the Company's overall financial position. The impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on levels of share based payments granted in the future. However, had the Company adopted SFAS 123R in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earning per share in Note 2 to the consolidated financial statements.
In November 2004, the FASB issued Statement of Financial Accounting Standard No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” (“SFAS 151”). SFAS 151 amends Accounting Research Bulletin (“ARB”) No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight handling costs and wasted materials (spoilage) should be recognized as current-period charges. In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect that the adoption of SFAS 151 will have a material effect on its financial position or results
of operations.
In March 2004, the FASB approved the consensus reached on the Emerging Issues Task Force (EITF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”). The objective of this Issue is to provide guidance for identifying impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired. In FASB Staff Position on EITF 03-1-1, the Board directed the FASB staff to delay the effective date for the measurement and recognition guidance contained in EITF 03-1. The disclosure requirements are effective only for annual periods ending after June 15, 2004. The Company does not believe the impact will be significant to the Company's overall results of operations or financial position.
3.   Marketable securities
The following is a summary of available-for-sale marketable securities:
December 31, 2003

December 31, 2004Cost

Gross
unrealized
gains

Estimated
fair
market
value

Cost

Gross
unrealized
gains

Gross
unrealized
losses

Estimated
fair
market
valueEquity securities

$
927


$
302


$
1,229


$
927


$
709


$
—


$
1,636Government bonds


—



—



—



7,000



—



38



6,962$
927


$
302


$
1,229


$
7,927


$
709


$
38


$
8,598During 2002, certain equity securities' decline in value was evaluated by the Company's management as other than temporary, and declines in the amount of $391 were recognized as loss in the statement of operations. The cost basis of these equity securities was written down to fair value as a new cost basis.
In October 2004, the Company invested in U.S. government bonds with maturities of up to four years.
The net adjustment to unrealized holding gains (losses) on available-for-sale marketable securities was included as a separate component of shareholders' equity: accumulated other comprehensive income (loss)” and amounted to $(395), $260 and $223 in 2002, 2003 and 2004, respectively.
F-21
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
3.   Marketable Securities(continued)
Aggregate maturities of government bonds for years subsequent to December 31, 2004 are:
Amortized cost

Estimated fair
market value2006

$
3,000


$
2,9832007


4,000



3,979$
7,000


$
6,9624.   Other accounts receivable and prepaid expenses
December 31,2003

2004Loans to employees

$
396


$
374Prepaid expenses


1,475



2,038Government authorities


251



788Advances for suppliers


6



163Other


95



298$
2,223


$
3,6615.   Inventories
December 31,2003

2004Raw materials, parts and supplies

$
2,591


$
2,343Work-in-progress


827



796Finished products


2,377



2,649$
5,795


$
5,7886.   Investment in other companies
a.

Investment in Tamir Fishman Ventures II, LLCThrough December 31, 2004, the Company had invested an aggregate amount of $6,273 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 11c regarding the Company's commitment to make additional investments in Tamir Fishman Ventures II, LLC.As a result of significant uncertainty over the future realization of the investment, during 2002, based on management's analysis, impairment losses were identified in the amount of $1,038. The impairment charge was included in other expenses. During 2003 and 2004, based on management's most recent analysis, no impairment losses have been identified.
F-22
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
6.   Investment in other companies (Continued)
b.

Investment in C-Signature Ltd.In April 2004, the Company entered into a convertible loan agreement with C-Signature Ltd., an Israeli company engaged in the development of biometric identity recognition technology. Pursuant to the agreement, the Company invested an aggregate amount of $1,100 in C-Signature including expenses in the amount of $50. This investment consisted of a $550 convertible loan, which automatically converted into Series A preferred shares of C-Signature upon the achievement of certain agreed upon milestones. Concurrently with the conversion of the loan, the Company invested the remaining $500 by purchasing additional Series A preferred shares of C-Signature. Following conversion of the loan and the closing of the purchase, the Company held 19.9% of the share capital of C-Signature.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.7.   Property and equipment
December 31,2003

2004Cost:Computers and peripheral equipment

$
11,949


$
12,757Office furniture and equipment


1,972



2,076Motor vehicles


574



650Leasehold improvements


1,399



1,26715,894



16,750Accumulated depreciation:Computers and peripheral equipment


10,874



11,638Office furniture and equipment


1,362



1,556Motor vehicles


329



388Leasehold improvements


882



93413,447



14,516Depreciated cost

$
2,447


$
2,234Depreciation expenses for the years ended December 31, 2002, 2003 and 2004 amounted to $2,102, $1,889 and $1,463, respectively.
F-23
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
8.   Intangible assets, net
a. Cost:
December 31,2003

2004Current technology (1)

$
1,054


$
1,054Customer list (2)


—



1,151Domain names (3)


—



930Patent (4)


—



5501,054



3,685Accumulated amortization:Current technology (1)


523



731Customer list (2)


—



82Domain names (3)


—



80Patent (4)


—



239Accumulated amortization


523



1,132Amortized cost

$
531


$
2,553(1)

Current technology—is being amortized over a period of five years and will be fully amortized in 2006.(2)

Customer list—is being amortized over a period of seven years and will be fully amortized in 2011. See also Note 1b for the acquisition of Aladdin Espana.(3)

Domain names—On May 27, 2004, the Company and Aladdin Systems Holdings Inc. (“ASH”) entered into a settlement agreement (the “Agreement”). Under the terms of the Agreement, the Company agreed to pay ASH $550 for the purchase of domain names and to reimburse ASH for the cost of implementing a name change and rebranding. As a result of the Agreement, the Company recorded an amount of $430 relating to the acquired domain names, which will be amortized over a period of 3 years. The allocation of the intangible assets acquired in the Agreement was done by a third-party valuation firm. The Company recorded an amount of $120 as general and administrative expenses.In November 2004, the Company purchased the URL “Aladdin.com” for the amount of $500. According to management this asset is deemed to have an indefinite useful life and will not be amortized.(4)

Patent—is being amortized over its useful life and will be fully amortized in 2011. See also Note 11b.b.

Amortization expenses for the years ended December 31, 2002, 2003 and 2004, amounted to $208, $221 and $609, respectively.c.

Estimated amortization expenses for the next five years:2005

$
5592006


4662007


2722008


2082009


209$
1,7149. Goodwill
As fully discussed in Note 14, the Company operates in two operating segments which are also the reporting units.
F-24
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
9. Goodwill (continued)
The changes in the carrying amount of goodwill for the year ended December 31, 2004 were as follows:Software
securities
(DRM)
segment

Enterprise
securities
segment

TotalBalance as of January 1, 2004

$
6,522


$
759


$
7,281Goodwill resulted from the acquisition of Aladdin Knowledge España, S.L. (See also note 1b) (1)


323



81



404Balance as of December 31, 2004

$
6,845


$
840


$
7,685(1)

Goodwill acquired was allocated to reporting units based on the expected benefits of the business acquired to each reporting unit.10. Accrued Expenses and Other Payables
December 31,2003

2004Employees and payroll accruals

$
3,160


$
3,316Accrued expenses


1,282



1,971Amount collected on behalf of a customer


647



—Deferred tax liability


—



145Income taxes payable


306



487Other


228



70$
5,623


$
5,98911. Commitments and Contingent Liabilities
a.

Lease commitments:The Company and its subsidiaries leased their premises and motor vehicles under various operating lease agreements which expire in 2009.Minimum lease commitments, under non-cancelable leases as of December 31, 2004, are as follows:Year ended December 31, 2004Facilities

Motor
vehicles

Total2005

$
1,417


$
1,137


$
2,5542006


1,057



703



1,7602007


518



295



8132008


128



28



1562009


111



15



126$
3,231


$
2,178


$
5,409Facilities lease expenses for the years 2002, 2003 and 2004 amounted to $1,618, $1,871 and $1,941, respectively.Motor vehicle lease expenses for the years ended December 31, 2002, 2003 and 2004 were approximately $895, $699 and $1,081, respectively.
F-25
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
11. Commitments and Contingent Liabilities (continued)
b.

Litigation:1.

In October 2002, a claim was brought by Hilgraeve, Inc. against the Company, its United States subsidiary and other companies, including one of its resellers, in respect of whom the Company agreed to represent and indemnify. The plaintiff claimed in this action that the eSafe product infringed on the plaintiff's United States patent. The plaintiff had requested an injunction and damages. This claim was settled at the beginning of March 2004. The terms of the settlement, which did not include an admission of liability, included payment of $550 in consideration of Hilgraeve's agreement to dismiss all its claims regarding the alleged infringement of its patent and an agreement to grant the Company a right to use its patent for the remaining useful life of the patent. The patent's original useful life was 17 years. As a result
of the above mentioned settlement the Company recorded in 2003 an accrual of $200 against general and administrative expenses which represented past periods in which the Company actually used the patent. In 2004, the balance of the payment was recorded as an intangible asset which will be amortized over the remaining useful life of the patent.2.

The Company and its subsidiary, Aladdin Knowledge Systems Inc., 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 the Company's MicroGuard product, which is discontinued, and certain of the Company's software DRM products, infringe a now-expired patent. By an amended complaint, an affiliate of Rainbow Technologies, the holder of the patent was added as a plaintiff. Plaintiffs are seeking damages in an unspecified amount relating to such alleged infringement, enhanced damages, interest, attorneys' fees and any further relief the Court may deem appropriate. Because the patent is expired, injunctive relief has not been requested and is not available to the plaintiff. The Company and its legal advisor believe
that the Company has good defenses to this complaint, and the Company intends to defend itself vigorously.c.

Investment commitment:In February 2000, the Company signed an agreement with Tamir Fishman Ventures II, LLC (“TFV”). Pursuant to the agreement, the Company committed to invest up to $8,475 on demand from TFV, out of which, as of December 31, 2004, the Company had already invested $6,273.d.

Stamp duty:Under Israel's Stamp Tax on Documents Law, certain documents are subject to a stamp tax. Recently promulgated regulations provide for a gradual phase-out of the stamp tax by 2008. In 2004, however, the tax authorities began an enforcement campaign involving extensive audits of companies' compliance with the stamp tax obligation with respect to all agreements which had been signed since June 2003.The Company has received legal advice that there are a variety of defenses relating to the obligation to pay stamp tax or to the amount to be paid. If the tax authorities do not accept the Company's defenses, the Company may be liable to pay a stamp tax with respect to the period beginning June 1, 2003 through December 31, 2004.
F-26
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
11. Commitments and Contingent Liabilities (continued)
The Company's management believes, based on the advice of legal counsel, that the ultimate disposition of this matter would not materially impact its financial position in the future.12.   Taxes on income
a.

Tax benefits under the Law for the Encouragement of Capital Investments, 1959 (“the Law”):Six expansion programs
      of Aladdin Knowledge Systems Ltd. (“AKS”) have been granted
      “Approved Enterprise” status, under the Law. For these expansion
      programs, the Company has elected alternative benefits, waiver of grants
      in return for tax exemptions. Pursuant thereto, the income of the Company
      derived from the following “Approved Enterprise” expansion programs
      is tax-exempt for the periods stated below and will be eligible for reduced
      tax rates thereafter. Such reduced tax rates are dependent on the level
      of non-Israeli investments in the Company, as described below. The Company
      is also a “foreign investment Company”, as defined by the Law
      and, as such, it is currently entitled in the third up to the sixth programs
      to a 10-year period of benefits and to a reduced tax rate of 20% (subject
      to change, based on the percentage of foreign ownership in each tax year).In 1996, the Company relocated its manufacturing activity to a new plant which was established in a region defined as a “Priority “A” Development Region”. This development region entitles AKS to higher tax benefits than the tax benefits existing where AKS's offices and research and development center are located.These benefits are included
      in the expansion programs, as detailed below:1.
    As of December 31, 2004, the benefits
      from the first three programs have expired.2.
    Income derived from the fourth program,
      which commenced December 31, 1994 and expired December 31, 2004,
      was tax exempt for the four-year period ended December 31, 1998, and
      is eligible for a reduced tax rate of 0%-20% for the six-year period ended
      December 31, 2004 (depending on the level of non Israeli investments
      in the Company).3.
    Income derived from the fifth program,
      which commenced December 31, 1996 and expires December 31, 2006,
      entitles AKS to a tax exemption for the two-year period ended December 31,
      1998, and to a reduced tax rate of 0%-20% for the eight-year period ending
      December 31, 2006 (depending on the level of non-Israeli investments
      in the Company).4.
Income derived from the sixth program, which commenced December 31, 1998 and expires December 31, 2008, entitles AKS to a tax exemption for the two-year period ended December 31, 2000, and to a reduced tax rate of 0%-20% for the eight-year period ending December 31, 2008 (depending on the level of non-Israeli Investments in the Company).The period of tax benefits, detailed
      above, is subject to limits of the earlier of 12 years from the commencement
      of production, or 14 years from the date approval.The entitlement to the above benefits
      is conditional upon the Company's fulfilling the conditions stipulated
      by the above law, regulations published thereunder and the instruments of
      approval for the specific investments in “Approved Enterprises”.
      In the event of failure to comply with these conditions, the benefits may
      be canceled and the Company may be required to refund the amount of the
      benefits, in whole or in part, including interest.Management believes that as of December 31, 2004, the Company met all of the aforementioned conditions.
F-27
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
12.   Taxes on income (continued)
The tax-exempt income attributable to the “Approved Enterprise” can be distributed to shareholders without imposing tax liability on the Company only upon the complete liquidation of the Company. As of December 31, 2004, retained earnings included approximately $27,922 in tax-exempt profits earned by the Company's “Approved Enterprise”. The Company has decided not to declare dividends out of such tax-exempt income. Accordingly, no deferred income taxes have been provided on income attributable to the Company's “Approved Enterprise”.If the retained tax-exempt income is distributed in a manner other than on the complete liquidation of the Company, it would be taxed at the corporate tax rate applicable to such profits as if the Company had not elected the alternative tax benefits (currently—10-25%) and an income tax liability would be incurred of approximately $5,584 as of December 31, 2004.Income from sources other than the “Approve Enterprise” during the benefit period, will be subject to tax at the regular corporate tax rate.Since the Company is operating under more than one approved program and since part of its taxable income is not entitled to tax benefits under the abovementioned law and is taxed at the regular corporate tax rate of 36%, (35% commencing July 2004 and 34%, 32%, 30% commencing 2005, 2006 and 2007 respectably), its effective tax rate is the result of a weighted combination of the various applicable rates and tax exemptions, and the computation is made for income derived from each program on the basis of formulas specified in the law and in the approvals.By virtue of this law, the Company is entitled to claim accelerated depreciation on equipment used by the “Approved Enterprise” during five tax years.b.

Measurement of taxable income under the Income Tax (Inflationary Adjustments) Law, 1985:Results for tax purposes are measured and reflected in real terms in accordance with the change in Israel's Consumer Price Index (“CPI”). As explained in Note 2, the consolidated financial statements are presented in U.S. dollars. The differences between the change in Israeli's CPI and in the NIS/dollar exchange rate causes a further difference between taxable income and the income before taxes reflected in the consolidated financial statements. In accordance with paragraph 9(f) of “SFAS No. 109”, the Company has not provided deferred income taxes on the difference between the functional currency and the tax bases of assets and liabilities.c.

Israeli tax reform:On July 24, 2002, Amendment 132 to Israel's Income Tax Ordinance (“the Amendment”) was approved by Israel's parliament and came into effect on January 1, 2003. The principal objectives of the Amendment were to broaden the categories of taxable income and to reduce the tax rates imposed on employees' income.The material consequences of the Amendment applicable to the Company include, among other things, imposing a tax upon all income of Israel residents, individuals and corporations, regardless the territorial source of income and certain modifications in the qualified taxation tracks of employee stock options.d.

Tax benefits under Israel's Law for the Encouragement of Industry (Taxation), 1969:The Company is an “industrial company”, as defined by the Law for the Encouragement of Industry (Taxes), 1969 and as such, is entitled to certain tax benefits, mainly amortization of costs relating to know-how and patents over eight years and accelerated depreciation.
F-28
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
12.   Taxes on income (continued)
e.

Income (loss) before taxes is comprised as follows:Year ended December 31,2002

2003

2004Domestic

$
1,302


$
1,988


$
6,572Foreign


(3,943
)


897



3,173$
(2,641
)

$
2,885


$
9,745f. Taxes on income is comprised as follows:
Year ended December 31,2002

2003

2004Current taxes

$
238


$
399


$
957Deferred taxes


2,500



(350
)


—$
2,738


$
49


$
957Domestic

$
200


$
216


$
723Foreign


2,538



(167
)


234$
2,738


$
49


$
957g. 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 31,2003

2004Deferred tax assets:Reserves and allowances

$
344


$
393Net operating loss carry forwards in subsidiaries


9,503



9,275Net deferred tax assets before valuation allowance


9,847



9,668Valuation allowance


(8,222
)


(7,938
)Total deferred tax assets

$
1,625


$
1,730Deferred tax liability from unrealized gain on available for sale


—



(145
)Total deferred tax liability


—



(145
)Net deferred tax assets

$
1,625


$
1,585Domestic

$
297


$
152Foreign


1,328



1,433$
1,625


$
1,585In assessing the realization of deferred tax assets, management considers whether it is more likely than not that all or some portion of the deferred tax assets will not be realized. The ultimate realization of the deferred tax assets is dependent upon the generation of future taxable income during the periods in which temporary differences are deductible and net operating losses are utilized. Based on consideration of these factors, the Company has established a valuation allowance of $8,222 and $7,938 at December 31, 2003 and 2004, respectively.
F-29
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
12.   Taxes on income (continued)
The Company's subsidiaries in the United Kingdom, Netherlands and Germany have estimated total available carryforward tax losses of $3,428, $75 and 9,205, respectively, to offset against future tax profits for an indefinite period.The Company's subsidiaries in the United States and in France have estimated total available carryforward tax losses of $12,858 and $1,017, to offset against future tax profits for periods of 15-20 years and five years, respectively.Utilization of U.S. net operating losses may be subject to a substantial annual limitations due to the “change in ownership” provisions of the Internal Revenue Code of 1986 and similar state provisions. The annual limitation may result in the expiration of net operating losses before utilization.h.

A reconciliation between the theoretical tax expense (benefit), assuming all income is taxed at the statutory tax rate applicable to income of the Company and the actual tax expense (benefit) as reported in the statement of operations, is as follows:Year ended December 31,2002

2003

2004Income (loss) before taxes, as reported in the consolidated statements of operations

$
(2,641
)

$
2,885


$
9,745Statutory tax rate


36%



36%



35%Theoretical tax expense (benefit) on the above amount at the Israeli statutory tax rate

$
(951
)

$
1,039


$
3,411Decrease in taxes resulting from “Approved Enterprise” benefits(1)


(176
)


(153
)


(353
)Tax adjustments in respect of inflation in Israel


(196
)


—



—-Tax adjustment in respect of foreign subsidiary different tax rate


38



43



20Deferred taxes on losses for which valuation allowance was provided


4,136



105



—Reversal of losses for which valuation allowance was provided in prior years


—



(750
)


(2,262
)Losses which no deferred tax recorded


—



—



81Non-deductible items


(113
)


(235
)


(55
)Other


—



—



115Actual tax expense (benefit)

$
2,738


$
49


$
957(1) Per share amounts (basic) of the tax benefit
     resulting from the exemption

$
(0.02
)

$
(0.01
)

$
(0.03
)Per share amounts (diluted) of the tax benefit
     resulting from the exemption

$
(0.02
)

$
(0.01
)

$
(0.03
)13.   Shareholders' equity
a.

The ordinary shares of the Company are quoted on The Nasdaq National Market, and since July 28, 2004, are also quoted on the Tel Aviv Stock Exchange.b.

The ordinary shares confer upon their holders the right to receive notice to participate and vote in general meetings of the Company, and the right to receive dividends, if declared.
F-30
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
13.   Shareholders' equity (continued)
c.

In October 2000, the Company initiated a share repurchase program, in which the Company is authorized to purchase up to $3,000 of its outstanding Ordinary shares, through an open-market transaction. As of December 31, 2002, the Company purchased 224,100 of its outstanding ordinary shares, at a weighted average price per share of $5.20. During 2004, all the shares were reissued from the share repurchase program.Such repurchases of Ordinary shares are accounted for as Treasury shares, and result in a reduction of shareholders' equity. When treasury shares are reissued, the Company accounts for the reissuance in accordance with Accounting Principles Board Opinion No. 6 “Status of Accounting Research Bulletins” (“APB No. 6”) and charges the excess of the repurchase cost over issuance price using the weighted average method to retained earnings. In case the repurchase cost is lower than the issuance price, the Company credits the excess cost to additional paid-in capital.d.

As a result of a grant of 100,000 options to the Company's Chief Executive Officer, the Company recorded in 2004 deferred compensation in the amount of $153, of which an amount of $87 was recorded as a compensation expense.e.

Employee Share Option Plans:Between 1993 and 2004, the Company implemented several Employee Share Options Plans (“the plans”). Total number of options authorized for grant under the plans amounted to 3,023,750. As of December 31, 2004, an aggregate of 209,574 options of the Company were still available for future grants.Under the Company's plans, full-time employees, officers and directors of the Company may be granted options to acquire Ordinary shares. The options granted are at an exercise price that equals the fair market value of the shares at the date of grant. The options generally vest over a period of two to four years from the date of grant, and expire no later than five to 10 years from the date of grant. Any options that are canceled or forfeited before expiration become available for future grants.A summary of the Company's share option activity under the plans is as follows:2002

2003

2004Number
of options

Weighted
average
exercise
price

Number
of options

Weighted
average
exercise
price

Number
of options

Weighted
average
exercise
priceOutstanding—beginning of the year


1,633,500


$
4.48



1,683,400


$
3.62



1,938,195


$
3.73Granted


397,100



1.20



638,150



4.80



157,100



15.10Exercised


—



—



(151,480
)


3.01



(940,234
)


3.91Forfeited


(347,200
)


4.88



(231,875
)


5.51



(82,607
)


3.68Outstanding—end of the year


1,683,400



3.62



1,938,195



3.73



1,072,454



5.57Options exercisable at the end of the year


660,392


$
5.29



1,023,583


$
4.15



453,712


$
3.22Weighted 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:
F-31
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
13.   Shareholders' equity (continued)
Weighted
      average fair value of
      options granted at an
      exercise price2002

2003

2004Equals fair value at date of grant

$
1.2


$
2.46


$
15.1Less than fair value at date of grant

$
—


$
1.82


$
—The options outstanding as of December 31, 2004, have been separated into exercise price categories, as follows:
Range of
exercise
price

Options
outstanding
as of
December 31,
2004

Weighted
average
remaining
contractual
life (years)

Weighted
average
exercise
price

Options
exercisable
as of
December 31,
2004

Weighted
average
exercise
price of
options
exercisable$1.20–2.67


478,202



6


$
1.9



252,960


$
1.87$3.50–4.80


252,752



4


$
4.48



178,052


$
4.34$8.5–8.52


185,400



9


$
8.51



20,200


$
8.52$13.05–15.75


153,600



10


$
15.07



—


$
—$18.00


2,500



4


$
18.00



2,500


$
18.001,072,454






$
5.57



453,712


$
3.22f.

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.14.   Segments of the company and related information
Commencing January 2004, the Company has two reportable segments related to continuing operations. The Software Security Digital Rights Management (DRM) Division develops and markets the following products: HASP HL and HASP NET, hardware-based software security systems, and privilege SCP which has been rebranded HASP SL, a software marketing, licensing and distribution platform. Both the software and the hardware products allow software publishers to manage licensing and distribution of their software theft and piracy.
The Enterprise Security Division develops and markets the USB-based eToken hardware device for user authentication and the eSafe line of content security solutions that protect PCs and networks against viruses, worms, spam and non-productive Internet-born content.
Until 2004, the Company's Chief Operation Decision Maker (the “CODM”) which is the Chief Executive Officer, reviewed financial information by revenues only since discrete financial information was not available at that time. During 2004, the Company started to produce discrete operating results and as a result the CODM began reviewing the results of the Company's business by the above mentioned segments.
The segments are managed separately because each segment requires different technology and marketing strategies. The Software Security (DRM) Division and Enterprise Security Division include some international sales mainly to the United States, Europe, and Japan.
a)

The following presents segment results of operations for the years ended December 31, 2002, 2003 and 2004:
F-32
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
14.   Segments of the company and related information (continued)
Year ended December 31,2002

2003

2004Revenues from external customers:Software security (DRM)

$
40,093


$
43,521


$
50,650Enterprise security


9,427



11,204



18,471Consolidated revenues

$
49,520


$
54,725


$
69,121Gross profit:Software security (DRM)

$
31,688


$
35,526


$
41,109Enterprise security


7,594



9,400



14,231$
39,282


$
44,926


$
55,340Operating (loss) income:Software security (DRM)


—
*


12,988



17,779Enterprise security


—
*


(10,578
)


(7,949
)Consolidated operating income

$
—
*

$
2,410


$
9,830Depreciation and amortization:Software security (DRM)

$
—
*

$
1,423


$
1,304Enterprise security


—
*


687



768Consolidated depreciation and amortization

$
—
*

$
2,110


$
2,072*

It was impracticable to provide operating income, depreciation and amortization by product line for the year ended December 31, 2002.b)

The Company does not allocate assets to its reportable segments, as assets generally are not specifically attributable to any particular segment. Accordingly, asset information by reportable segment is not presented. Where the underlying assets can be specifically attributed to a segment, the related depreciation and amortization have been classified accordingly. The remaining depreciation is allocated based on a percentage of revenue. Total revenues are attributed to geographic areas based on the location of customers:Year ended December 31,2002

2003

2004Revenues from sales to unaffiliated customers:Israel

$
1,949


$
2,025


$
2,381United States


17,484



17,621



19,721Germany


9,214



12,124



15,384Europe (excluding Germany)


13,273



13,826



18,724Japan


4,827



6,780



9,212Others


2,773



2,349



3,699$
49,520


$
54,725


$
69,121Long-lived assets:Israel

$
6,762


$
6,009


$
7,200United States


3,398



2,983



2,632Germany


323



325



263Europe (excluding Germany)


827



719



2,146Japan


201



223



231$
11,511


$
10,259


$
12,472
F-33
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
14.   Segments of the company and related information (continued)c)   Total revenues from outside customers are distributed among the following product lines:

Year ended December 31,2002

2003

2004Tokens (including HASP, Hardlock andMicroguard)

$
37,388


$
41,217


$
49,707eSafe


7,274



7,662



10,911eToken


2,153



3,542



7,560Others


2,705



2,304



943$
49,520


$
54,725


$
69,12115. Selected statements of operations dataa.   Financial income (expenses):
Year ended December 31,2002

2003

2004Financial expenses:Impairment of available-for-sale marketable securities

$
(391
)

$
—


$
—Loss from derivative instrument


—



—



(234
)Other


(143
)


(219
)


(248
)(534
)


(219
)


(482
)Financial income:Income from interest on marketable securities


—



—



25Interest


171



161



370Foreign currency remeasurement gains


827



538



140Other


27



—



—1,025



699



535$
491


$
480


$
53b.   Other expenses, net:
Impairment of investment in other company

$
(1,038
)

$
—


$
—Other, net


106



(5
)


(138
)$
(932
)

$
(5
)

$
(138
)
F-34
Aladdin Knowledge Systems Ltd. and its SubsidiariesNOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(U.S. dollars in thousands)
15. Selected statements of operations data (Continued)
c.

Net earnings (loss) per share:The following table sets forth the computation of basic and diluted net earnings (loss) per share:Year ended December 31,2002

2003

20041. Numerator:Net income (loss) to shareholders of Ordinary shares

$
(6,636
)

$
2,736


$
8,788Numerator for basic and diluted net earnings (loss) per share—income (loss) available to Ordinary shareholders

$
(6,636
)

$
2,736


$
8,7882. Denominator:Weighted average number of shares


11,477



11,477



11,940Weighted average number of treasury shares


(224
)


(190
)


—Denominator for basic net earnings (loss) per share


11,253



11,287



11,940Effect of dilutive securities:Employee stock options


—
*


663



1,060Dilutive potential Ordinary shares


—
*


663



1,060Denominator for diluted net earnings (loss) per share—adjusted weighted average shares, assumed exercise of options


11,253



11,950



13,000* Antidilutive.
F-35