RAINBOW TECHNOLOGIES INC - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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FORM 10-K
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(Mark One)

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

For the fiscal year ended December 31, 2001

OR

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

Commission file number: 0-16641

RAINBOW TECHNOLOGIES, INC.
(Exact name of Registrant as specified in its charter)

Delaware 953745398
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)

50 Technology Drive, Irvine, California 92618
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (949) 450-7300

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

Securities registered pursuant to Section 12(g) of the Act:
Common Stock

Indicate by check mark whether the Registrant (i) 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 (ii) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

As at March 11, 2002, the aggregate market value of the voting stock of the
Registrant (based upon the closing sales price of the shares on the NASDAQ
National Market System) held by non-affiliates was approximately $229,697,489.

As at March 11, 2002, there were outstanding 26,554,623 shares of Common
Stock of the Registrant, par value $.001 per share.

DOCUMENTS INCORPORATED BY REFERENCE

1. Portions of the Registrant's Proxy Statement to be submitted to the
Commission on or before April 30, 2002, are incorporated by reference into Part
III.

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1

INTRODUCTORY NOTE

The Annual Report on Form 10-K contains certain forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934 and the Company intends that such
forward-looking statements be subject to the safe harbors created thereby. These
forward-looking statements include (i) the existence and development of the
Company's technical and manufacturing capabilities, (ii) anticipated
competition, (iii) potential future growth in revenues and income, (iv)
potential future decreases in costs, and (v) the need for, and availability of
additional financing.

The forward-looking statements included herein are based on current
expectations that involve a number of risks and uncertainties. These
forward-looking statements are based on the assumption that the Company will not
lose a significant customer or customers or experience increased fluctuations of
demand or rescheduling of purchase orders, that the Company's markets will
continue to grow, that the Company's products will remain accepted within their
respective markets and will not be replaced by new technology, that competitive
conditions within the Company's markets will not change materially or adversely,
that the Company will retain key technical and management personnel, that the
Company's forecasts will accurately anticipate market demand, that there will be
no material adverse change in the Company's operations or business and that the
Company will not experience significant supply shortages with respect to
purchased components, sub-systems or raw materials. Assumptions relating to the
foregoing involve judgments with respect to, among other things, future
economic, competitive and market conditions, and future business decisions, all
of which are difficult or impossible to predict accurately and many of which are
beyond the control of the Company. In addition, the business and operations of
the Company are subject to substantial risks which increase the uncertainty
inherent in the forward-looking statements. In light of the significant
uncertainties inherent in the forward-looking information included herein, the
inclusion of such information should not be regarded as a representation by the
Company or any other person that the objectives or plans of the Company will be
achieved.

Item 1. Business

General

Rainbow Technologies, Inc., a Delaware corporation, (the "Company") is a
leading global provider of Information Technology (IT) security solutions. The
Company applies its core technologies and expertise in a variety of products and
services that solve its customer's problems including:

o Effective protection against piracy and related licensing solutions
for software publishers

o Equipment to secure sensitive satellite and link communications in
accordance with U.S. Government requirements

o High assurance security components, including a complete range of
standard public key infrastructure (PKI) components, and custom
security product development for banking, healthcare, government,
postal and defense customers

o Services, including development of secure Internet portals, wireless
application integration, security training, security architecture and
intrusion auditing for banking, health care, government, education,
enterprise and defense sectors

o Convenient key-chain devices providing reliable identity for web
applications, workstations and custom security products

o Acceleration of secure Internet and wireless web transactions

o Easy to deploy, end-to-end, hardware secure-access to business-
critical web applications

The Company is structured in three business segments: eSecurity Products, Secure
Communications Products and Spectria. eSecurity focuses on commercial security
products, including solutions for reliable identity, secure internet and
wireless transaction acceleration, licensing solutions for software publishers,
and easy to deploy Web security solutions. Secure Communications provides
products and services for enterprise, government, and defense applications for
products providing security for classified information, for products providing
personal identity authentification for government and defense applications, and
custom design services for enterprises, government and defense applications
requiring either extraordinary performance and/or security. Spectria offers
consulting services for developing specialized applications, including solutions
for secure enterprise web portals, wireless applications, enterprises network
intrusion auditing and security training for enterprise IT staff. These three
business segments are increasing working closely together.

The Company's principal offices and subsidiaries are located in North
America, Europe and Asia. Unless the context otherwise requires, the term
"Company" refers to Rainbow Technologies, Inc. and its subsidiaries. The Company
benefits from global sales reach and distributed development capability,
leveraging effective software and hardware engineering capabilities in Delhi,
India, Beijing, China and Irvine, Torrance and Long Beach, California, U.S.A.

2

Industry Background

Rainbow Technologies, Inc. serves seven major markets with its products and
services: 1) security solutions for software publishers, 2) strong personal
identity authentication solutions, 3) secure network transaction and secure
network communication acceleration components, 4) high assurance security
components, 5) high assurance secure communication products for enterprise,
government, and defense applications, 6) enterprise integration consulting
services, and 7) enterprise network intrusion auditing and enterprise network
security IT training services.

eSecurity serves the following markets:

1. Security solutions for software publishers - Since its inception in
1984, the Company has been a leading developer and supplier of
proprietary security products that prevent unlicensed use and piracy
of software, and products that protect the confidentiality of digital
content transmitted over networked systems. Software distribution
methods have evolved from physically shipping retail packaged products
for use with stand-alone personal computers and single licensed
software programs to markets where there are many different methods of
providing software access to users. Now besides all of the original
software distribution methods used, computers are connected to
networks, including the Internet, and software may be obtained from an
Internet distribution site and licenses may be purchased for multiple
users within entire enterprises. In addition, some software providers
have been trying new business models: For example, Application Service
Providers (ASP) provide users their products functionality through
controlled access to a web site that provides their applications
functionality to the user. Users may be charged based upon how much
they actually use the application. In this new business model for
software distribution, the problem of software distribution becomes a
problem of access control and usage accounting.

2. Strong personal identity authentication solutions - Several factors
are driving the increased growth and interest in this market: i)
government regulations within health care and banking requiring
greater security of customer records; ii) dramatic increase in the
frequency and severity enterprise network intrusions and attacks; and
iii) responses to the events of September 11th and resulting efforts
to boost the security of nations critical infrastructures. In addition
to these factors, large-scale Public Key Infrastructure (PKI) projects
have been more complex and slower to deploy than originally expected.
As a result, some PKI companies have made efforts to diversify and to
reinvent themselves in order to better align with existing market
conditions.

3. Secure network transaction and secure network communication
acceleration components - Continued growth in internet e-commerce
transactions and requirements for secure communications along with
broad acceptance of the advantages of hardware acceleration of
security protocols are factors significantly impacting this market.
These factors have motivated the entrance of many competitors into
this market and are rapidly driving the underlying components to
become commodities. As a result, there has been steady erosion in
pricing on some categories security protocol acceleration hardware and
there has been also a more pervasive inclusion of security protocol
acceleration hardware within many network appliances.

4. High assurance security components - Increased networked intrusion
attempts and attacks, new government regulations concerning privacy of
consumer information, as well as concerns for national infrastructure
security are motivating the continued deployment of enhanced high
assurance security for health care, financial, and government
applications. Some specific high assurance initiatives, such as
Identrus for banking, are being deployed slower than expected because
of complexities of deployment and application support.

Secure Communications serves the following markets:

5. High assurance secure communication products for enterprise,
government, and defense applications - Increasing awareness and
responses to the events resulting from September 11th have contributed
to motivating continued growth of this market.

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Spectria serves the following markets:

6. Enterprise integration consulting services - Industry professional
expertise for overseeing enterprise network security, for deploying
enterprise wide PKI solutions, for developing and deploying secure
enterprise web portals, and for deploying secure wireless applications
are limited.

7. Enterprise network intrusion auditing and enterprise network security
IT training services - Scarcity of enterprise security talent and
increase intrusions and attacks directed towards enterprises are
factors causing the continued increase of enterprises relying on
outsourcing services for dealing with enterprise network security
issues.

Strategy

eSecurity Products

The Company has kept pace with the evolving market by applying its
expertise in creating solutions that support alternate methods of software
distribution. The Company believes that it is well positioned in the market with
alternate products to continue its existing market leadership position.

The Company has continued to develop new products that are easier to deploy
and also products with enhanced security to better address emerging market
requirements. The Company's sales and application efforts have been directed
towards financial, health care and government applications. In addition, the
Company believes that with its easier to deploy and more secure solutions, it is
well positioned for strong growth from this market leadership position.

The Company will continue to use and develop its own security protocol
acceleration "Application Specific Integrated Circuits" (ASICs) and will also
procure merchant security protocol ASICs for product applications within
components and appliances that could benefit from a merchant supplied ASIC
solution. The Company believes that it holds significant advantages in i)
developed broad operating system and cryptographic application support for its
secure transaction hardware acceleration products; ii) developed ASICs and
expertise relating to high performance encryption of government classified
information; iii) expertise relating to high assurance acceleration products
meeting and exceeding Federal Information Processing Standards (FIPS) standards
for health care, financial, government, and defense applications; iv) products
and expertise for easy-to-deploy web-security solutions including security
protocol acceleration; and v) continued brand strength and brand recognition
within this market and product category. The Company intends on continuing to
introduce new products that provide greater performance, greater security, and
that are easier to deploy. Furthermore, the Company believes that because of
these advantages it will continue to grow its customers served through our
direct and distribution sales channels.

The Company has kept pace with the evolving market by applying its
expertise in creating alternative high assurance security for health care,
financial, and government applications. The Company believes that it is well
positioned in the market with alternate products to continue to grow its
position within this market.

Secure Communications Products

The Company's Secure Communications Products strategy is to offer to the
U.S. Government and to commercial enterprises requiring high levels of
information security, products and development services that implement network
security, access control, and telecommunication security solutions. In
furtherance of this strategy, the Company has built relationships with industry
and Government organizations which expand the Company's sales opportunities. The
Company has also invested resources in pursuing opportunities by developing
innovative telecommunications and network security technology and products for
the U.S. Government and commercial applications. Certified under ISO 9001
standards for its secure communications operations, the Company utilizes
technology and products developed for the U.S. Government to create and
introduce new commercial information and network security products.

The Company's strategy for this market is to continue to offer the U.S.
Government and commercial enterprises requiring the highest level of security,
products and development services to assist clients with assessing, designing
and implementing computer

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network security, access control and secure communications products solutions.
The Company has built relationships with industry organizations to expand sales
opportunities and has also invested significant resources in pursuing
opportunities to develop innovative network security technology and products for
the U.S. Government and commercial applications. The Company intends to utilize
technology and products developed for the U.S. Government to create and
introduce new commercial network security products. In addition to Secure
Communications' products, the Company also markets eSecurity and Spectria
products and services to the U.S. Government.

Spectria

Spectria is the Company's technology and business consulting division,
specializing in security services and custom application development. Spectria's
mission is to provide world class, secure solutions to mid-market clients.

There is increasing demand from the Company's product customers for
Spectria services such as secure application design, PKI implementation and
secure integration of disparate systems. The Company's eSecurity, Secure
Communications and Spectria divisions are working closely together, combining
their products and services, to provide customized, complete security solutions
to prospects and customers.

Spectria's clients include AT Systems, Toyota Motor Corporation, Westcon
Group, Pepperdine University, State of Hawaii - Department of Education and Mesa
Unified Schools. Its partners include Microsoft, IBM, Netsolve, Symbol and
others.

The Company will continue to utilize its expertise to integrate solutions
and provide services to enterprises for health care, financial, transportation
and government applications. The Company will continue its consulting services
to work with clients to design, implement and support secure solutions based on
emerging technologies. The Company has extensive experience collaborating with
leading industry partners, including Microsoft, IBM, Lotus, Cisco and Symbol.
The Company also offers services in eBusiness security, eBusiness development,
eBusiness integration, information portals and wireless and mobile computing
solutions.

The Company will continue to utilize its expertise and will also leverage
existing customer relationships to continue to provide intrusion auditing
services. The Company expects its related revenues to continue to grow with this
market.

eSecurity Products

Products for Security Solutions for Software Publishers

These products combine sophisticated hardware and software encryption
technology to prevent the illegal distribution and use of software. When
software is protected by the Company's Sentinel suite of hardware products (the
"key"), the software program sends queries to the key that is attached to the
parallel port of the computer. The key immediately evaluates each query and
responds. The correct response ensures that standard operation of the software
will continue without interruption. If the key is not present, the software will
not operate. The keys incorporate the Company's proprietary "algorithms"
programmed into Company designed ASIC computer chips. An algorithm is a
mathematical procedure for manipulating digital information with the intent of
securing the information. An ASIC is a logic circuit designed for a specific use
and implemented in an integrated circuit. Once Sentinel protection is
implemented, developers need only include a Sentinel key with each software
package shipped. The end-user installs the software as usual, then simply plugs
the enclosed Sentinel key into the appropriate port on the computer.

The Company also offers software-based products that provide software
license management and provide software protection products for the distribution
of software over the Internet. These products offer software publishers greater
flexibility in how their products are licensed and distributed.

The Company's Secure Solutions Products include:

SentinelSuperpro. Featuring the Company's proprietary ASIC technology, this
is the industry's first key to combine multiple algorithms with programmable
memory for increased security and flexibility. This product is compatible with a
broad range of platforms and operating systems.

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SentinelEve3. Provides software protection for Apple Macintosh-based
software publishers.

Sentinel License Manager (LM). Allows publishers to issue licenses that
control the use of their network products. LM supports flexible licensing models
and allows remote upgrades. The Company's customer's end-users benefit from
quick access to additional licenses, a range of terms and the ability to "try
and buy". LM supports secure distribution of software on CD-ROM or the Internet.
In conjunction with Sentinel LM, SentinelExpress provides the security to
distribute demos or licensed applications on the Internet, and obtain software
licenses from a website. SentinelExpress allows consumers to evaluate, purchase
and activate software easily through a developer's website 24-hours a day.

Products for Secure Network Transaction and Secure Network Acceleration

The Company's secure acceleration products use patent-pending technology to
provide Internet commerce companies and manufacturers of Internet computer
servers, firewalls, routers and switching equipment with increased security and
accelerated Internet commerce transaction capabilities. A "firewall" is
technology used for preventing unwanted inbound or outbound data at the boundary
of a computer network based upon a set of established rules. A "router" is a
computer-networking device that is responsible for directing the "route" data
will travel to its final destination.

CryptoSwift. A high performance security co-processor for Internet computer
transaction servers engaged in Internet commerce, electronic brokerage,
financial services and other applications that require security functions of
privacy and strong user authentication. It economically addresses the problem of
server overload due to the calculation intense mathematics associated with
"public key" encryption. This form of encryption is widely deployed in all web
servers and browsers in use today and is the basis for Secure Sockets Layer
(SSL), Secure Electronic Transaction (SET), Wireless Transport Layer Security
(WTLS) protocols. CryptoSwift is an industry standard PCI bus card with a
proprietary ASIC co-processor. Using patent-pending "wide integer" multipliers,
it performs all the mathematics associated with public key encryption, allowing
the server CPU to perform less calculation intense tasks. CryptoSwift offers
plug-in compatibility with Netscape, Microsoft, Sun, HP and LINUX server and
operating system software.

NetSwift. NetSwift is an easy to deploy network appliance that provides
security protocol acceleration for eCommerce and mCommerce transactions
utilizing SSL and WTLS security protocols. NetSwift provides scalable
performance and is suitable for line speed applications to one gigabit per
second (gbps).

Products for High Assurance Security

The Company's high assurance security products are used in applications in
which security of the information is critical. These products comply with
Federal Information Processing Standard (FIPS) for information security. Some
high-assurance applications demand security for keying information. For example,
if keying information is stored on a system disk drive, some type of virus
software could be uploaded by a hacker to locate keying information and e-mail
that information out of the system. If an attacker has physical access to a
system, the attacker could use readily available electronic test equipment to
monitor a system to deduce the keying information. In high-assurance
applications the theft of keying information could result in theft of extremely
large sums of cash, exposure of highly sensitive data, or compromise of a
critical authentication process.

CryptoSwift Hardware Security Module (HSM) - provides additional security
required to protect sensitive keying information from malicious attacks and
theft. With its tamper-active design, the CryptoSwift HSM's evasive measures
defeat physical attacks through detection and responses to ensure the integrity
and confidentiality of keying information.

Products for Strong Personal Identity Authentication

The Company's identity authentication products use a variety of
cryptographic techniques to support alternative modes of identity authentication
and are compatible with many industry standard software applications and
operating systems.

iKey. IKey is a security token that can serve as a solution to a wide
variety of computer security and information control issues. The iKey can be
plugged into any standard computer "USB port," and can serve to authenticate
users for ensuring secure access to VPNs and computer network equipment. A "USB
port" is a standard connectivity technology included on most new computers,
servers and portable computer devices. Through user identification data
contained in each iKey, the network is able to grant access according to the
user's authorization level.

6

Secure Communications Products

The Company believes the importance of protecting the privacy, authenticity
and security of satellite, terrestrial, and computer network communications has
increased in direct proportion to technological advances, capabilities, and
overall growth in telecommunications industries. Information security remains
critical to government and defense applications and in light of recent events,
is increasingly valued by private sector businesses to protect communications.
The Company's Secure Communications Products consist of ASICs, modules,
electronic assemblies, and stand-alone products to protect electronic
information. The Products are designed, developed, and produced by the Company
for use in government and commercial applications.

The Company's Secure Communications Products are currently categorized into
four general areas of customer applications:

Satellite Space-Based Products. These products consist of ASICs and "black
boxes" to decrypt (unscramble) satellite command uplinks and encrypt (scramble)
the satellite downlinks.

Satellite Ground-Based Products. This equipment is used to encrypt
satellite command uplinks and decrypt satellite downlinks.

Voice Communications Products. These consist of ASICs and modules that
encrypt and decrypt voice transmissions over wireless or landline communication
networks.

Data Communications Products. These products, which consist of ASICs,
modules, electronic assemblies, and equipment, encrypt and decrypt digital
information transmitted over communication links, networks, or into storage
media.

Spectria

Products for Enterprise Services

Business Intelligence Services. Business Intelligence turns raw data into
accessible, meaningful information to support better business decisions. The
Company's Business Intelligence team links data sources, integrates complex
back-end systems and designs data cubes to efficiently group data for meaningful
presentation, analysis and reporting. The Company's clients use this information
to recognize consumer trends, identify additional sales opportunities, detect
cost reduction potentials and discover operational efficiencies. The Company's
approach to a Business Intelligence project includes identifying key dimensions
and measures, performing dimensional modeling, identifying data sources and
deploying one or more data marts. This approach allows for rapid design,
creation and Proof of Concept prior to deploying business intelligence
solutions.

Wireless Computing. The Company offers packaged and customized wireless
solutions for applications such as: data collection; mobile transportation and
logistics; Enterprise Resource Planning integration; warehouse management;
work-in-progress; asset tracking; consignment inventory; compliance labeling;
retail ordering; sales force automation; and wireless applications.

Enterprise Security Services. The Company provides Enterprise Security
Services, services including introductory enterprise network security training
for enterprise IT staff; enterprise network intrusion auditing - a service in
which the Company probes client networks for weaknesses and vulnerabilities and
reports findings along with recommendations; security assessments; crises
management; and security application development. Spectria uses its XIM
methodology and Three Layer Analysis to develop custom applications with
designed-in security. Spectria has developed secure, integrated applications for
a variety of industries including: finance, banking and insurance, supply chain
management, K-12 and higher education.

Research and Development

Because of the rapid technological advances and other changes affecting the
Company's markets, the Company's competitive position hinges upon the adaptation
of its products to such changes in the market. Introduction of new products that
gain market acceptance is crucial to sustainable growth. Accordingly, the
Company directs research and development activity toward applying its encryption
technology to design and develop new security products and the enhancement of
existing products.

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The Company has evolved its development of strategy towards the integration
of its successful line of security components into end-user solutions for the
network environment. To remain competitive, the Company has launched a global
development model which expands engineering capability and optimizes costs.
Expenditures for research and development for the years ended December 31, 2001,
2000 and 1999 were $10,209,000, $11,485,000, and $10,863,000, respectively, or
as a percentage of revenues, 7%, 7% and 9%, respectively. The Company believes
that as a result of its development efforts, its technological leadership could
broaden in the future.

The Company performs research and development with regard to its Secure
Communications Products in connection with U.S. Government contracts. The costs
incurred by the Company in connection with such research and development
activities are substantially recoverable by the Company pursuant to the terms of
these contracts. The Company believes that some of the research and development
performed under such contracts can be applied to the emerging issues of
information security. There were no unfunded research and development
expenditures related to Secure Communications Products for the years ended
December 31, 2001, 2000 and 1999.

Sales and Marketing

eSecurity Products

The Company has its own direct sales and marketing personnel for eSecurity
Products in North America, Europe and Asia Pacific. In addition, the Company has
over 50 distributors worldwide. The Company markets its eSecurity Products to
software publishers throughout the world for use with their software programs
selling at retail for $500 or more in the United States, and for use with lower
priced software programs sold internationally.

The Company's direct sales force calls on targeted software publishers in
order to increase usage of the Company's products. The direct sales force
pursues a global marketing plan that focuses on multinational software.

The Company markets its security components and solutions to security
product manufacturers on an OEM basis, integrators for major products on a
reseller basis, and directly to end customers implementing major projects. The
Company's direct sales force calls on Fortune 1000 companies including financial
institutions and health care providers, as well as Government agencies
implementing electronic commerce or web based transaction systems.

For 2001, 2000, and 1999, 57%, 63% and 60%, respectively, of the Company's
eSecurity Products sales were made in the United States and 43%, 37% and 40%,
respectively, were made internationally. During 2001, 2000 and 1999, the Company
had no single customer that accounted for ten percent or more of the Company's
eSecurity Products revenue.

The Company is also developing a worldwide family of qualified value added
resellers (VARs) that work to incorporate our products into complete solutions
for end customers, and access the market with our security solutions. Many of
the projects using our security components are based on Public Key
Infrastructure (PKI) and require integration with PKI products from other
vendors.

All operating units of the Company use electronic marketing, exhibit at
trade shows and advertise in online and physical trade publications. The
Company's worldwide sales engineering team provides pre-sales support, and its
technical support team maintain and provide web, email, and telephone support
for any post-sale customer requirements.

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Secure Communications Products

The Company markets its Secure Communications Products directly to the U.S.
Government and commercial enterprises requiring high levels of information
security. The products and development services offered to these organizations
and enterprises implement network security, access control, and
telecommunication security solutions. Also, the Company maintains close
relationships with government-related agencies, the aerospace industry and
commercial institutions. Through these relationships, the Company receives
contracts for services and products on a selected source basis. In addition,
contracts are awarded to the Company in response to requests for proposal from
U.S. Government agencies, aerospace companies and commercial institutions.

Spectria

Spectria markets its services to mid-sized organizations throughout the
United States. Spectria has expertise in a variety of industries including
finance, banking, insurance, education, manufacturing, and logistics. Spectria
has a direct sales force, but also obtains leads from its partners such as
Microsoft, IBM, Netsolve, and Symbol.

Manufacturing

eSecurity Products

The Company's eSecurity Products are manufactured by subcontractors in the
United States, Asia and Europe from components specified and approved by the
Company. The components include custom ASIC chips, typical electronic components
and standard electronic hardware. The Company maintains control over the
purchasing of materials and the planning and scheduling of the manufacturing and
assembly process. After assembly of the components and functional test of the
product, deliveries are made to the Company's facilities in the United States,
Europe and Asia where the products are inspected, tested and configured. The
Company believes that it is the lowest cost producer of eSecurity products and
believes that this will continue to be a competitive advantage.

For the SentinelSuperpro product, the Company currently has one supplier of
the custom ASIC chip. For other eSecurity products, the Company currently has
relationships with chip suppliers that have multiple foundries available to
produce the ASIC chips. If the suppliers are unable to fulfill the Company's
requirements, the Company may experience an interruption in the production of
its products until an alternative source of supply is developed. The Company
maintains a six month inventory of ASIC chips based on current sales levels in
order to limit the potential for such an interruption. The Company believes that
there are a number of companies capable of commencing the manufacture of its
ASIC chips within six months of such an interruption.

Secure Communications Products

The Company's Secure Communications Products manufacturing operations
include the testing of ASICs and the assembly and testing of its satellite
flight and ground units. Production subcontractors and manufacturing companies
are utilized for the higher volume access control, stored value, link and
network secure communications products. The Company maintains control over the
planning and scheduling of the manufacturing and assembly process. The company
has certification under ISO 9001 standards for all such operations.

The Company has specific cryptographic technology embedded into ASICs that
are fabricated to the Company's specifications by ASIC manufacturers. The
Company currently has relationships with four such ASIC circuit manufacturers.
These ASIC circuits are processed to the specifications of the customer and the
Company. Any interruption in the availability of these ASIC circuits could have
a material adverse effect on the operations of the Company.

The Company currently has a manufacturing relationship with Bulova
Technologies LLC (BT) and Sanmina-SCI Corporation (SSCI) to manufacture the
Company's principal Secure Communications Products. Any interruption in the
availability of this product would have a material adverse effect on the
operations of the Company. BT and SSCI are dual sources manufacturing this
product. SSCI's manufacturing agreement, dated August 31, 2000, expires in March
2003. BT's manufacturing agreement, dated May 30, 2001, expires in February
2004.

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Backlog

The Company manufactures its eSecurity Products on the basis of its
forecast of near-term demand and maintains inventory in advance of receipt of
firm customer orders. Customer orders are generally placed on an "as needed"
basis and are usually shipped by the Company within one week after receipt of
the order.

As of December 31, 2001, the backlog for the Company's Secure
Communications Products is in excess of six months of 2002 revenues for this
business segment.

Intellectual Property

The Company believes that the value of its security products is dependent
upon its proprietary algorithms and encryption techniques remaining "trade
secrets." The Company has obtained copyright protection on certain of its
products and trademark protection for certain of its trade names. The Company
also has been granted several patents, both U.S. and foreign, and has applied
for patent protection for certain technology included in its various product
offerings. There can be no assurance that the Company's proprietary technology
will remain a secret or that others will not develop similar technology and use
such technology to compete with the Company. Furthermore, there can be no
assurance that patents will be granted for the inventions for which the Company
has applied or for which it may apply in the future.

Competition

eSecurity Products

The markets targeted by eSecurity are highly competitive and characterized
by rapid technological advances in computer hardware and software development.
The Company believes it is an industry leader. The Company's principal
competitors are Aladdin Knowledge Systems, Ltd., SCM Microsystems, Inc., and
Macrovision Corporation. The Company believes that it offers the most cost
effective secure software distribution products available to software
publishers. Although certain of the Company's competitors offer lower prices,
the Company believes that its technical support services and the ease of
implementation of its products favorably distinguish the Company from its
competitors.

Secure Communication Products

The Company's principal competitors for its Secure Communications Products
are General Dynamics, L-3 Com, ViaSat and Cylink Corporation. The Company
believes its innovation, unique products, reaction capability, cryptographic
expertise and large number of U.S. Government certified products are a
significant competitive advantage.

Spectria

Spectria's principal competitors consist of a variety of national and
regional service providers and Big 5 consulting firms.

Employees

The Company presently employs approximately 550 full-time employees of
which approximately 360 are located in the United States. The Company believes
that its employee relations are excellent. The employees and the Company are not
parties to any collective bargaining agreements.

Item 2. Properties

The Company's executive offices and principal facility are located in an
approximately 61,000 square foot building in Irvine, California. The Company
leases the facility pursuant to a lease expiring July 2005.

The Company owns an approximately 5,000 square foot facility in the United
Kingdom that is used primarily for northern European sales and administration.
The Company also owns an approximately 8,000 square foot facility in Paris,
France, that is used primarily for southern European sales and administration.

10

The Company leases a facility in Torrance, California, that is used as a
sales, administration, design and production facility. The lease is for
approximately 48,000 square feet and expires in 2002. As of March 2002, the
Company is currently negotiating its lease renewal.

The Company leases facilities in Long Beach and San Diego, California, that
are used as sales, administration, design and development facilities. The leases
total approximately 21,000 square feet and expire in 2004 and 2005.

The Company leases another facility in Irvine, California, that is
currently not being used and was part of the restructuring of eSecurity
operations in the third quarter of 2001. The lease is for approximately 44,000
square feet and expires in December 2005. As of December 31, 2001, the Company
is still seeking to sublease the facility.

Item 3. Legal Proceedings

In September 1998, a patent infringement action was filed against the
Company by Globetrotter, Inc., alleging that certain of the Company's products
infringe patents owned by Globetrotter. The complaint seeks unspecified monetary
damages and a permanent injunction banning the use of the products alleged to
infringe the Globetrotter patents. On September 24, 2001, the District Court
granted partial summary judgment in favor of the Company as it relates to
allegations by Globetrotter. The Company has filed a counterclaim alleging
antitrust and unfair competition and has been vigorously prosecuting its
antitrust and other business tort claims. The counterclaims are presently set
for trial on September 10, 2002.

In July 1998, a patent infringement claim was filed against the Company by
Andrew Pickholtz, alleging that certain of the Company's products infringe
patents owned by Pickholtz. The complaint seeks unspecified monetary damages.
The Company filed a motion for summary judgment of noninfringement that was
decided in favor of the Company in December 2000. In January 2001, Mr. Pickholtz
filed a notice of appeal. After considering legal briefs filed by the Company
and by Mr. Pickholtz, the Court of Appeals for the Federal Circuit heard oral
arguments in the case on November 7, 2001, but as of February 28, 2002, has not
yet ruled on the appeal. The Company continues to believe the claims are without
merit as found by the trial court and intends to continue to vigorously defend
against any infringement claims made by Mr. Pickholtz.

The Company is also involved in other legal proceedings and claims arising
in the ordinary course of business. The Company does not believe that any
liabilities related to the legal proceedings to which it is a party are likely
to be, individually or in the aggregate, material to the Company's consolidated
financial condition, results of operations or cash flows.

Item 4. Submission of Matters to a Vote of Security Holders

Neither the Board of Directors, nor any security holder, submitted any
matter during the fourth quarter of the fiscal year covered by this Report to a
vote of the security holders through solicitation of proxies or otherwise.

11

PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters

The Common Stock of the Company is traded on the NASDAQ National Market
System under the symbol "RNBO." The following table sets forth high and low
"sales" prices of the shares of Common Stock of the Company for the periods
indicated (as reported by the National Quotation Bureau).

High Low
------ ------
2002 First Quarter (through February 28, 2002)... 8.770 7.360
2001 First Quarter............................... 5.734 4.875
2001 Second Quarter.............................. 5.600 5.150
2001 Third Quarter............................... 3.950 3.120
2001 Fourth Quarter.............................. 7.670 7.350
2000 First Quarter............................... 25.125 10.250
2000 Second Quarter.............................. 25.313 10.625
2000 Third Quarter............................... 26.000 15.188
2000 Fourth Quarter.............................. 27.063 14.630

All per share data reflects the Company's 2-for-1 stock split effective
October 9, 2000.

As of February 28, 2002, there were approximately 189 holders of record of
the Company's Common Stock including those shares held in "street name."

The Company has never paid cash dividends on its Common Stock and the Board
of Directors intends to retain all of its earnings, if any, to finance the
development and expansion of its business. However, there can be no assurance
that the Company can successfully expand its operations or that such expansion
will prove profitable. Future dividend policy will depend upon the Company's
earnings, capital requirements, financial condition and other factors considered
relevant by the Company's Board of Directors.

Item 6. Selected Financial Data

The following selected historical financial data has been derived from the
audited consolidated financial statements of the Company. This information
should be read in conjunction with the Company's Consolidated Financial
Statements and the Notes thereto as well as "Management's Discussion and
Analysis of Financial Condition and Results of Operations", included in Item 7.
Share amounts for all years presented have been adjusted to reflect the impact
of a 2-for-1 stock split effective October 9, 2000 and a 3-for-2 stock split
effective July 1, 1998.

Years Ended December 31
----------------------------------------------------------
2001(1) 2000(2) 1999 1998(3) 1997
--------- --------- --------- --------- ---------
(dollars in thousands, except per share data)

Selected Consolidated Statement of Operations Data:
Total revenues ............................................ $ 137,261 $ 163,284 $ 121,089 $ 109,232 $ 94,724
Income (loss) before taxes ................................ (34,384) 22,289 13,164 8,922 19,202
Net income (loss) ......................................... (23,517) 14,446 8,137 2,490 11,332
Net income (loss) per share:
Basic .................................................. $ (.90) $ .58 $ .35 $ .11 $ .49
Diluted ................................................ (.90) .52 .34 .10 .47
Shares used in calculating net income (loss) per share:
Basic ..................................................... 26,055 24,965 23,054 23,398 23,306
Diluted ................................................... 26,055 27,932 24,212 23,946 23,936
Selected Consolidated Balance Sheet Data:
Total assets .............................................. $ 145,965 $ 171,209 $ 130,538 $ 109,753 $ 103,051
Working capital ........................................... 68,991 86,169 48,936 59,763 55,776
Long-term debt, net of current portion .................... 476 726 1,014 1,458 1,616
Shareholders' equity ...................................... 116,739 139,748 97,890 92,201 86,359

12

- ----------

(1) The results of operations for the year ended December 31, 2001 reflect
third quarter ended September 30, 2001 restructuring charges of $6.4
million and other charges which include provision for bad debts of $1.6
million, reserve for excess and obsolete inventory of $7.4 million,
write-off of capitalized and developed software of $2.4 million, warranty
reserve of $1.8 million, goodwill impairment charge of $4.0 million, an
investment impairment charge of 1.2 million, foreign currency transaction
loss of $1.3 million and an unrealized loss on marketable securities of
$3.5 million.

(2) The results of operations for the year ended December 31, 2000 reflect an
asset impairment charge of $2.2 million and an unrealized gain on
marketable trading securities of $2.8 million.

(3) The results of operations for the year ended December 31, 1998 reflect an
asset impairment charge of $3.9 million, a $1.5 million write-off of
acquired in-process research and development and a $1.3 million write-off
of a fully impaired investment.

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations

The following is management's discussion and analysis of certain
significant factors that have affected the profitability of the Company's
business segments (eSecurity Products, Secure Communications Products and
Spectria) and its consolidated results of operations and financial condition
during the periods included in the accompanying consolidated financial
statements. The following should be read in conjunction with the consolidated
financial statements and related notes.

Critical Accounting Policies and Estimates

The Company's financial statements are based on the selection and
application of significant accounting policies, which require management to make
significant estimates and assumptions. The Company believes that the following
are some of the more critical judgment areas in the application of its
accounting policies that currently affect its consolidated financial condition
and results of operations.

Revenue Recognition

eSecurity recognizes revenues from product sales at the time of shipment.
Secure Communications recognizes revenue and profit as work progresses on
long-term contracts using the percentage-of-completion method, which relies on
estimates of total expected contract revenue and costs. Catalog product revenues
and revenues under certain fixed-price contracts calling for delivery of a
specified number of units are recognized as deliveries are made. Revenues under
cost-reimbursement contracts are recognized as costs are incurred and include
estimated earned fees in the proportion that costs incurred to date bear to
total estimated costs. Certain contracts are awarded on a fixed-price incentive
fee basis. Incentive fees on such contracts are considered when estimating
revenues and profit rates and are recognized when the amounts can reasonably be
determined. The costs attributed to units delivered under fixed-price contracts
are based on the estimated average cost per unit at contract completion. Profits
expected to be realized on long-term contracts are based on total revenues and
estimated costs at completion. Revisions to contract profits are recorded in the
accounting period in which the revisions are known. Estimated losses on
contracts are recorded when identified. For research and development and other
cost-plus-fee type contracts, the Company recognizes contract earnings using the
percentage-of-completion method in the proportion that costs incurred to date
bear to total estimated costs. Spectria recognizes revenues from eBusiness
consulting fees as services are performed on a time and materials basis.

Accounts Receivable

The Company is required to estimate the collectibility of its trade
receivables and unbilled costs and fees. A considerable amount of judgment is
required in assessing the ultimate realization of these receivables including
the current credit-worthiness of each customer. Significant changes in required
reserves have been recorded in the third quarter 2001 and may occur in the
future depending on future market conditions.

Inventory

The Company is required to state its inventories at the lower of cost or
market. In assessing the ultimate realization of inventories, the Company is
required to exercise judgment in its assessment of future demand requirements
and compare that with the current or committed inventory levels. The Company
recorded charges for required reserves in the third quarter 2001 due to changes
in strategic direction and market conditions. It is possible that changes in
required inventory reserves may continue to occur in the future due to market
conditions.

Income Taxes

The Company currently has significant deferred tax assets, which are
subject to periodic recoverability assessments. There is no valuation allowance
provided against the deferred tax assets as the Company believes it is more
likely than not that these assets will be realized. This conclusion is based
upon the expectation of future taxable income and tax planning strategies. The
Company's judgment regarding future taxable income may change due to future
market conditions and its ability to continue to successfully execute its
restructuring program and other factors. These changes, if any, may require
possible material adjustments to these deferred tax asset balances.

13

Impairment of Goodwill

The Company periodically evaluates acquired businesses for potential
impairment indicators. The Company's judgment regarding the existence of
impairment indicators is based on legal factors, market conditions and
operational performance of acquired businesses. Future events could cause the
Company to conclude that impairment indicators exist and that goodwill
associated with acquired businesses is impaired. Any resulting impairment loss
could have a material adverse impact on the Company's consolidated financial
condition and results of operations (see Note 1 to Notes to Consolidated
Financial Statements).

Capitalized Software Development Costs

The Company's policy on capitalized software costs determines the timing of
recognition of certain development costs. In addition, this policy determines
whether the cost is classified as development expense or cost of license fees.
Management is required to use professional judgment in determining whether
development costs meet the criteria for immediate expense or capitalization.

Statement of Financial Accounting Standards No. 86, "Accounting for the
Costs of Computer Software to be Sold, Leased or Otherwise Marketed," requires
capitalization of certain software development costs subsequent to the
establishment of technological feasibility. Based upon the Company's product
development process, technological feasibility is established upon completion of
a working model. Amortization of capitalized software development costs
commences when the products are available for general release to customers and
is determined using the straight-line method over the expected useful lives of
the respective products.

Outlook

During the quarter ended December 31, 2001, the Company has experienced
sequential improvement in its business segments and a return to profitability.
The Company's Secure Communications business segment is forecast to have the
highest growth rate as demand for security products for the U.S. government and
other high assurance markets is increasing.

Although business spending on technology is weak and the spending outlook
is uncertain, the Company is forecasting improvement in eSecurity as business
spending on security is expected to increase.

The focus of our Spectria consulting business segment is shifting to
support complete solution sales by its Secure Communications and eSecurity
segments. Any such support services will be included in our Secure
Communications and eSecurity revenues. Spectria' reported revenues, therefore,
are forecast to be at or near current levels.

Year ended December 31, 2001 compared to year ended December 31, 2000

On a consolidated basis, revenues for the year ended December 31, 2001
decreased 16% from the prior year to $137,261,000. The decrease is due to lower
revenues in the eSecurity and Spectria segments, partially offset by higher
revenues in the Secure Communications segment. Revenues from international
markets for 2001 decreased 27% to $23,979,000 while revenues from domestic
markets decreased by 13% to $113,282,000. The decrease in domestic revenues was
due to the aforementioned decreases in eSecurity and Spectria segments,
partially offset by an increase in Secure Communications segment. The decrease
in revenues from international markets was primarily due to a decrease in
revenues in Europe partially offset by an increase in revenues in Asia Pacific.
The decrease in revenues in Europe was primarily due to lower demand for
security products while the increase in revenues in Asia Pacific was primarily
due to higher revenues in China and revenues generated by the Company's new
office in Japan.

eSecurity Products revenue for the year ended December 31, 2001 decreased
37% to $56,388,000 as compared with $89,031,000 for 2000. The decrease in
revenue was primarily due to the decline in OEM markets for CryptoSwift SSL
acceleration devices and decreased demand in North America and Europe for
business software applications.

Secure Communications Products revenue for the year ended December 31, 2001
increased 20% to $66,509,000 as compared with $55,392,000 for 2000. The increase
in revenues was primarily due to continued growth in demand for network security
products.

Spectria revenues for the year ended December 31, 2001 decreased 24% to
$14,364,000 as compared with $18,861,000 for 2000. The decrease was due to the
decline in demand for Information Technology consulting services because of the
economic weakness experienced during 2001.

Gross profit from eSecurity Products for the year ended December 31, 2001
was 33% of revenues as compared with 69% of revenues for the year ended December
31, 2000. The decrease was primarily due to charges recorded in the third
quarter of 2001 which included $7,414,000 in inventory reserves, $1,782,000 in
warranty reserves and a $2,392,000 write-off of capitalized and developed
software. Additionally, fixed overhead costs over a lower revenue base and
increases in certain component costs contributed to the decrease (see Note 12 to
Notes to Consolidated Financial Statements).

Gross profit from Secure Communications Products for the year ended
December 31, 2001 was 23% of revenues compared with 24% of revenues for the year
ended December 31, 2000.

14

Gross profit from Spectria revenues for the year ended December 31, 2001
was 38% of revenues as compared with 40% of revenues for the year ended December
31, 2000. The slight decrease in gross profit was due to a decrease in higher
margin projects.

There can be no assurance that the Company will improve or maintain the
level of gross profit percentages it experienced during the year ended December
31, 2001.

Consolidated selling, general and administrative expenses for the year
ended December 31, 2001 were 34% of revenues compared with 29% of revenues for
the year ended December 31, 2000. Selling, general and administrative expenses
for the year ended December 31, 2001 decreased by $335,000 as compared with
2000. The decrease was primarily due to the decrease in staffing and
compensation, partially offset by other charges recorded in the third quarter of
2001 relating to provision for bad debts of $1,612,000 (see Note 12 to Notes to
Consolidated Financial Statements).

Total research and development expenses for the years ended December 31,
2001 and 2000 were 7% of revenues. Research and development expenses for the
year ended December 31, 2001 decreased by $1,276,000 as compared with 2000. The
dollar decrease was primarily due to reductions in staff and decreases
in compensation as a result of the restructuring in the third quarter of 2001.

Goodwill amortization in 2001 decreased by $387,000 to $2,787,000 as
compared with $3,174,000 in 2000. The decrease was primarily due to the goodwill
impairment recorded in the third quarter of 2001 (see Note 1 to Notes to
Consolidated Financial Statements).

In the third quarter of 2001, the Company restructured and consolidated its
Digital Rights Management (DRM) & iVEA operations into eSecurity. As a result,
the Company recorded restructuring charges of $6,402,000 relating to office
space reduction and severance (see Note 12 to Notes to Consolidated Financial
Statements).

In the third quarter of 2001, the Company performed a review for impairment
of its goodwill relating to the InfoSec and Wyatt acquisitions and determined
that the carrying value of the goodwill was impaired. Impairment is based on the
excess of the carrying amount over the fair value of those assets. Fair value is
determined using a discounted cash flow analysis. As a result, the Company
recorded a goodwill impairment charge of $4,030,000 (see Note 1 to Notes to
Consolidated Financial Statements).

During the year ended December 31, 2001, the Company recognized foreign
currency losses of $24,000, primarily due to dollar denominated deposit accounts
maintained in Europe. During the year ended December 31, 2000, the Company
recognized foreign currency gains of $78,000, also primarily due to dollar
denominated deposit accounts maintained in Europe. Such foreign currency gains
and losses result from movement in the value of the U.S. dollar against the
functional currencies used by the Company's foreign subsidiaries.

The effective tax rate was 32% for the year ended December 31, 2001
compared to 35% for the year ended December 31, 2000. The effective tax rate for
2001 decreased primarily due to the nondeductibility of certain charges recorded
in the third quarter of 2001 including goodwill impairment. At December 31,
2001, the Company has federal net operating loss carryforwards of approximately
$14,473,000 which begin to expire in 2020. In addition, the Company is successor
to net operating losses of approximately $4,876,000 from the acquisition of
Wyatt River Software, Inc. which are subject to the change of ownership
provisions and are limited to approximately $204,000 per year.

At December 31, 2001, the Company had a federal research and development
credit carryforward of approximately $699,000 which will begin to expire in
2018.

Year ended December 31, 2000 compared to year ended December 31, 1999

On a consolidated basis, revenues for the year ended December 31, 2000
increased by 35% from the prior year to $163,284,000. The increase is due to
higher revenues in the eSecurity segment and the Secure Communications segment.
Revenues from international markets for 2000 increased by 23% to $32,900,000
while revenues from domestic markets increased by 38% to $130,384,000. The
increase in domestic sales was due to the aforementioned increases in the
eSecurity segment and the Secure Communications segment. The increase in
revenues from international markets was primarily attributable to an increase in
sales generated through our offices opened during 1999 in Australia, Taiwan,
India and China. The average selling price per product unit for the year ended
December 31, 2000 increased approximately 21% from the year ended December 31,
1999. Unit volume for the year ended December 31, 2000 increased by 11% as
compared with 1999.

eSecurity revenues for the year ended December 31, 2000 increased 33% to
$89,031,000 as compared with $67,046,000 in 1999. The revenue growth was
primarily due to an increase in sales of the Company's CryptoSwift product line
partially offset by a decline in sales of the Company's Sentinel product line
due to a slowdown in the high-end software industry in the North American
market.

Secure Communications Products revenue for the year ended December 31, 2000
increased 22% to $55,392,000, as compared with $45,297,000 for 1999. The revenue
growth was primarily due to the growth in the Company's KIV-7 Link Encryptor
line.

15

Spectria revenues for the year ended December 31, 2000 increased 116% to
$18,861,000 as compared with $8,746,000 for 1999. The revenue growth was
primarily due to Systematic, InfoCal and InfoSec being included in the
consolidated results of operations of the Company for a full year in fiscal 2000
and only a partial year in 1999-see Acquisitions below.

Gross profit from eSecurity Products for the year ended December 31, 2000
was 69% of revenues compared with 71% of revenues for the year ended December
31, 1999. The decrease in gross profit was primarily due to a higher percentage
of OEM business with lower selling prices and margins relating to its
CryptoSwift product line.

Gross profit from Secure Communications Products for the year ended
December 31, 2000 was 24% of revenues compared with 15% of revenues for the year
ended December 31, 1999. The increase in gross profit was due to the change in
mix from more profitable product contracts to less profitable research and
development contracts.

Consolidated selling, general and administrative expenses for the year
ended December 31, 2000 were 29% of revenues compared with 27% of revenues for
the year ended December 31, 1999. Selling, general and administrative expenses
for the year ended December 31, 2000 increased by $13,610,000 as compared with
1999. This increase was primarily due to additional staff and higher marketing
expenses for new product introductions, the expansion of internal sales offices
and higher professional expenses.

Total research and development expenses for the year ended December 31,
2000 were 7% compared with 9% of revenues for the year ended December 31, 1999.
Research and development expenses for the year ended December 31, 2000 increased
by $622,000 compared with 1999 because of additional staffing. Current research
and development activities are primarily focused on additional ASIC development
for future products, and the expansion of Company's existing Internet
infrastructure product line.

Goodwill amortization in 2000 increased by $736,000 to $3,174,000 as
compared with $2,438,000 in 1999, due to the amortization of goodwill related to
prior year acquisitions being amortized for a full year in 2000 and current year
earn-out payments related to those acquisitions being added to goodwill in 2000.

During the year ended December 31, 2000, the Company recognized foreign
currency gains of $78,000, primarily due to dollar denominated deposit accounts
maintained in Europe. During the year ended December 31, 1999, the Company
recognized foreign currency gain of $752,000, also primarily due to dollar
denominated deposit accounts maintained in Europe. Such foreign currency gains
and losses result from the movement in the value of the U.S. dollar against the
functional currencies used by the Company's foreign subsidiaries.

The effective tax rate was 35% for the year ended December 31, 2000
compared to 38% for the year ended December 31, 1999. The effective tax rate for
2000 decreased due to the reversal of a valuation allowance related to the
Company's German subsidiary and expansion of the Company's international
operations.

At June 30, 2000, the Company performed a review for impairment of the
long-lived assets related to Quantum Manufacturing Technologies, Inc. ("QMT"), a
majority owned subsidiary of the Company. Based on its evaluation, the Company
determined that all of the long-lived assets related to QMT were fully impaired
and as result recorded an impairment charge of $2,173,000. Effective July 1,
2000 QMT is accounted for on the equity method as the Company's ownership
percentage decreased below fifty percent.

Liquidity and Capital Resources

The Company's principal sources of operating funds have been from
operations. Net cash provided by operating activities was $21,032,000 for the
year ended December 31, 2001 while net cash used in operating activities for the
year ended December 31, 2000 was $1,813,000. Net cash provided by operating
activities for the year ended December 31, 1999 was $11,127,000. Operating
activities in 2001 included a decrease in accounts receivable of $12,818,000 and
an increase in deferred income taxes of $13,178,000, and an increase of
$21,022,000 due to third quarter charges, and other non-cash expenses which
include $4,773,000 of restructuring charges, $6,714,000 provision for excess and
obsolete inventory, $1,907,000 for warranty provision, $4,030,000 for goodwill
impairment, $1,206,000 for a write-off of long-term investment, and $2,392,000
for a write-off of capitalized software.

Net cash used in investing activities for 2001 of $10,940,000 decreased
from 2000 primarily due to a decrease in capitalized software costs of
$5,032,000. Investing activities in 2000 included $2,756,000 related to
acquisition of the Systematic and $1,000,000 related to the acquisition of
Infocal.

Net cash used in financing activities in 2001 of $2,306,000 included
$1,034,000 of exercise of common stock options while net cash provided by
financing activities in 2000 of $9,847,000 included $12,942,000 of exercise of
common stock options.

16

At December 31, 2001, the Company's subsidiaries in the United Kingdom,
Germany, France, Netherlands and Japan carry approximately $741,000, $779,000,
$769,000, $2,814,000 and $1,450,000, respectively, in interest earning deposits
which may result in foreign exchange gains or losses due to the fact that the
functional currency in those subsidiaries is not the U.S. dollar.

Management believes that the effect of inflation on the business of the
Company for the past three years has been minimal.

The Company believes that its current working capital of $68,991,000 and
anticipated working capital to be generated by future operations will be
sufficient to support the Company's working capital requirements through at
least December 31, 2002.

Acquisitions

On October 22, 1999, the Company completed the acquisition of InfoCal LLC
("InfoCal"). InfoCal creates collaborative intranet/extranet applications,
knowledge portals and distance learning applications and specializes in
messaging strategy migration and implementation. The initial transaction value
was $3.5 million, including $3.0 million paid in cash and 73,060 split adjusted
shares of Rainbow common stock valued at $500,000. In fiscal 2000, an additional
$1.0 million was paid out related to an earn-out provision. This acquisition was
accounted for using the purchase method of accounting. Approximately $4.5
million has been allocated to goodwill and is being amortized on a straight-line
basis over ten years. Results of operations for InfoCal are included in the
Company's consolidated results of operations beginning on October 22, 1999.

On September 16, 1999, the Company completed the acquisition of InfoSec
Labs, Incorporated ("InfoSec"). InfoSec has core competency in both enterprise
and internet security solutions and is renowned for its security assessment and
education programs. The total transaction value was $3.1 million, including $1.6
million paid in cash and 240,418 split adjusted shares of Rainbow common stock
valued at $1.5 million. This acquisition has been accounted for using the
purchase method of accounting. Approximately $3.1 million was allocated to
goodwill and is being amortized on a straight-line basis over ten years. Results
of operations for InfoSec are included in the Company's consolidated results of
operations beginning on September 16, 1999 (see Note 1 to Notes to Consolidated
Financial Statements).

On May 12, 1999, the Company completed the acquisition of Systematic
Systems Integration ("Systematic") for an initial purchase price of $9.6 million
in cash with an additional cash payment of $1.5 million accrued at December 31,
1999 and paid in January 2000. An additional $1.3 million was paid out in fiscal
2000 related to an earn-out provision based upon revenues. This acquisition was
accounted for using the purchase method of accounting. The entire purchase price
and earn-out payments have been allocated to goodwill. The goodwill is being
amortized on a straight-line basis over ten years. Systematic is a
California-based eCommerce integration services firm that enables companies to
seamlessly integrate diverse software and hardware platforms, communication
systems and Internet technologies. Results of operations for Systematic are
included in the Company's consolidated results of operations beginning on May
12, 1999.

Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statements of Financial Accounting Standards ("SFAS") No. 141 "Business
Combinations" and No. 142 "Goodwill and other Intangible Assets". SFAS No. 141
addresses financial accounting and reporting for a business combination and
requires all business combinations to be accounted for using the purchase
method. SFAS No. 141 is effective for any business combinations initiated after
June 30, 2001. SFAS No. 142, effective for the Company January 1, 2002,
addresses the initial recognition and measurement of goodwill and other
intangible assets acquired in a business combination. Goodwill and other
intangible assets with indefinite lives will no longer be amortized but instead
be subject to impairment tests at least annually. The Company will apply the new
rules on accounting for goodwill and other intangible assets from prior
acquisitions beginning in the first quarter of 2002. Application of the
non-amortization provisions of SFAS No. 142 is estimated to result in a decrease
of goodwill amortization of approximately $2 million per year. The Company will
perform the first of the required impairment tests of goodwill and
indefinite-lived intangible assets under the new rules during 2002. The Company
has not yet determined the effect these tests will have on its consolidated
results of operations and financial condition.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets". SFAS No. 144, effective for the
Company January 1, 2002, supersedes FASB Statement No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,"
and the accounting and reporting provisions of APB Opinion No. 30, "Reporting
the Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," for the disposal of a segment of a business (as previously
defined in that opinion). SFAS No. 144 requires that one accounting model be
used for long-lived assets to be disposed of by sale, whether previously held
and used or newly acquired, and broadens the presentation of discontinued
operations to include more disposal transactions than were included under the
previous standards. SFAS No. 144 is expected to have no impact upon initial
adoption.

Item 7a. Quantitative and Qualitative Disclosures About Market Risk

Market risk generally represents the risk that losses may occur in the
values of financial instruments as a result of movements in interest rates,
foreign currency exchange rates and commodity prices. The Company is exposed to
changes in financial market conditions in the normal course of its business due
to its use of certain financial instruments as well as transacting in various
foreign currencies and translation of its foreign subsidiaries financial
statements to the U.S. dollar.

Interest Rate Risk

At December 31, 2001 and 2000, the Company's marketable available-for-sale
securities included $1,072,000 and $1,582,000, respectively, of fixed income
securities. These securities are subject to interest rate risk and may decline
in value when interest rates change. In January 2002, $800,000 of the Company's
available-for-sale fixed income securities were sold. These investments do not
represent a material market risk to the Company. The Company places
substantially all of its interest bearing investments with major financial
institutions and by policy limits the amount of credit exposure to any one
financial institution.

Equity Price Risk

The Company holds investments in marketable available-for-sale and trading
equity securities which are subject to price risk. The fair value of such
investments as of December 31, 2001 and 2000 were $1,195,000 and $5,251,000,
respectively. The potential change in the fair value of these investments,

17

assuming a 10% decline in prices, would be approximately $120,000 and $525,000,
respectively, at December 31, 2001 and 2000.

Foreign Exchange Rate Risk

The Company operates internationally and has adopted local currencies as
the functional currencies for its foreign subsidiaries because their principal
economic activities are most closely tied to the respective local currencies.
This exposes the Company to market risk from changes in foreign exchange rates
to the extent that transactions are not denominated in the U.S. dollar. In
consolidation, the Company converts the accounts of its foreign subsidiaries
from the functional currency to the U.S. dollar. As a result, the Company faces
the risk that the foreign currencies will have declined in value as compared to
the U.S. dollar, resulting in a foreign currency translation loss. Assuming an
adverse 10% foreign exchange rate fluctuation, the Company would have
experienced translation losses of approximately $2,841,000 and $2,861,000 at
December 31, 2001 and 2000, respectively.

The Company's earnings are affected by fluctuations in the value of the
U.S. dollar as compared to foreign currencies as a result of the sales of its
products in foreign markets. Assuming an adverse 10% foreign exchange rate
fluctuation, the Company would have had a decrease in net income of
approximately $200,000 and $600,000 for the years ended December 31, 2001 and
2000, respectively. This calculation assumes that each exchange rate would
change in the same direction relative to the U.S. dollar. In addition to the
direct effects of changes in exchange rates which are a changed dollar value of
the resulting sales, changes in exchange rates also affect the volume of sales
or the foreign currency sales price as competitors' products become more or less
attractive. The Company's sensitivity analysis of the effects of changes in
foreign currency exchange rates does not factor in a potential change in sales
levels or local currency prices.

Item 8. Financial Statements and Supplementary Data

The Consolidated Financial Statements and Schedule of the Company are
listed in Item 14(a) and included herein on pages F-1 through F-23.

Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

The Company has not had any disagreement with its independent auditors on
any matter of accounting principles or practices or financial statement
disclosure.

18

PART III

Item 10. All Directors and Executive Officers of the Registrant

Reference is made to the information appearing under the caption "Election
of Directors" in the Company's Proxy Statement to be submitted to the Commission
on or before April 30, 2002.

Item 11. Executive Compensation

Reference is made to the information appearing under the caption "Executive
Compensation" in the Company's Proxy Statement to be submitted to the Commission
on or before April 30, 2002.

Item 12. Security Ownership of Certain Beneficial Owners and Management

Reference is made to the information appearing under the caption "Security
Ownership of Certain Beneficial Owners and Management" in the Company's Proxy
Statement to be submitted to the Commission on or before April 30, 2002.

Item 13. Certain Relationships and Related Transactions

Reference is made to the information appearing under the caption "Certain
Relationships and Related Transactions" in the Company's Proxy Statement to be
submitted to the Commission on or before April 30, 2002.

PART IV

Item 14. Exhibits, Financial Statements, Schedules and Reports on Form 8-K

(a) 1. Consolidated Financial Statements

Report of Independent Auditors

Consolidated Balance Sheets at December 31, 2001 and 2000

Consolidated Statements of Operations for the years ended December 31,
2001, 2000 and 1999

Consolidated Statements of Shareholders' Equity for the years ended
December 31, 2001, 2000 and 1999

Consolidated Statements of Cash Flows for the years ended December 31,
2001, 2000 and 1999

Notes to Consolidated Financial Statements

2. Consolidated Financial Statement Schedule

II. Consolidated Valuation and Qualifying Accounts for the years
ended December 31, 2001, 2000 and 1999

All other schedules are omitted because they are not applicable or the
required information is shown in the consolidated financial statements or notes
thereto.

19

3. Exhibits

Exhibit
Number Description
------ -----------

2(i) Agreement and Plan of Reorganization, dated as of January 26,
1995 among the Company, Rainbow Acquisition Inc., a California
corporation and a wholly owned subsidiary of Rainbow, and
Mykotronx, Inc., a California corporation ("Mykotronx")
(incorporated by reference to the Company's Registration
Statement on Form S-4 under the Securities Act of 1933, as
amended, effective on April 20, 1995, Registration No.
33-89918).

2(ii) Agreement and Plan of Merger, dated September 30, 1996, by and
among the Company, RNBO Acquisition Corporation, a Nevada
corporation and a wholly-owned subsidiary of the Company, and
Software Security, Inc., a Connecticut corporation
(incorporated by reference to Exhibit 2(ii) of the Company's
1996 Annual Report on Form 10-K under the Securities Exchange
Act of 1934 filed in March 1997 (the "1996 10-K")).

2(iii) Agreement and Plan of Merger, dated March 6, 1998, by and among
the Company, WRS Acquisition Corp, a California corporation and
wholly owned subsidiary of the Company, and Wyatt River
Software, Inc. (incorporated by reference to Exhibit 2(iii) of
the Company's 1997 Annual Report on Form 10-K under the
Securities Exchange Act of 1934 filed in March 1998 (the "1997
10-K")).

3(i) Articles of Incorporation of Rainbow, as amended (incorporated
by reference to Exhibit 3(a) to Rainbow's Registration
Statement on Form S-18 under the Securities Act of 1933, as
amended, filed on July 20, 1987 -- File No. 33-15956-LA (the
"S-18 Registration Statement")).

3(ii) By-Laws of Rainbow (incorporated by reference to Exhibit 3(b)
to the S-18 Registration Statement).

4(a) See Exhibit 3(i).

4(b) See Exhibit 3(ii).

4(c) Rights Agreement, dated as of July 29, 1997, between the
Company and U.S. Stock Transfer Corporation, as Rights Agent
(incorporated by reference to Exhibit 4(c) to the Company's
1997 10-K).

10(a) Lease for premises at 50 Technology Drive, Irvine, California,
dated June 1, 1995, between the Company and Birtcher Medical
Systems, Inc., a California corporation (filed as an exhibit to
the Company's 1995 Form 10-K).

10(b) Agreement, dated October 1996, between the Company and National
Semiconductor Corporation (incorporated by reference to Exhibit
10(b) of the Company's 1998 Annual Report on Form 10-K under
the Securities Exchange Act of 1934 filed in March, 1999 (the
"1998 10-K")).

10(c) Agreement, dated December 1998, between the Company and EM
Microelectronic -- Marin S.A. (incorporated by reference to
Exhibit 10(c) of the 1998 10-K).

10(d) 1990 Incentive Stock Option Plan as amended (incorporated by
reference to Exhibit 10(j) of the 1991 10-K).

10(e) Employment Agreement, dated February 16, 1990, between the
Company and Walter W. Straub (incorporated by reference to
Exhibit 10(j) of the 1989 10-K).

10(f) Change of Control Agreement, dated February 16, 1990, between
the Company and Walter W. Straub (incorporated by reference to
Exhibit 10(k) of the 1989 10-K).

10(g) Employment Agreement, dated January 15, 1992, between the
Company and Peter M. Craig (incorporated by reference to
Exhibit 10(m) of the 1991 10-K).

10(h) Change of Control Agreement, dated January 15, 1992, between
the Company and Peter M. Craig (incorporated by reference to
Exhibit 10(n) of the 1991 10-K).

10(i) Employment Agreement, dated January 5, 1995, between the
Company and Norman L. Denton, III (incorporated by reference to
Exhibit 10(j) of the Company's 1994 Annual Report on Form 10-K
under the Securities Exchange Act of 1934, filed in March 1995
(the "1994 10-K")).

10(j) Change of Control Agreement, dated January 5, 1995, between the
Company and Norman L. Denton, III (incorporated by reference to
Exhibit 10(k) to the 1994 10-K).

10(k) Employment Agreement, dated January 5, 1995, between the
Company and Patrick E. Fevery (incorporated by reference to
Exhibit 10(l) of the 1994 10-K).

10(l) Change of Control Agreement, dated January 5, 1995, between the
Company and Patrick E. Fevery (incorporated by reference to
Exhibit 10(m) of the 1994 10-K).

20

Exhibit
Number Description
------ -----------

10(m) Employment Agreement, dated January 5, 1995, between the
Company and Paul A. Bock (incorporated by reference to Exhibit
10(n) of the 1994 10-K).

10(n) Change of Control Agreement, dated January 5, 1995, between the
Company and Paul A. Bock (incorporated by reference to Exhibit
10(o) of the 1994 10-K).

10(o) Employment Agreement, dated April 7, 1997, between the Company
and Aviram Margalith (incorporated by reference to Exhibit
10(o) of the 1997 10-K).

10(p) Change of Control Agreement, dated April 7, 1997, between the
Company and Aviram Margalith (incorporated by reference to
Exhibit 10(p) of the 1997 10-K).

10(q) Employment Agreement, dated January 1, 1998, between the
Company and Laurie Casey (incorporated by reference to Exhibit
10(q) of the 1997 10-K).

10(r) Change of Control Agreement, dated January 1, 1998, between the
Company and Laurie Casey (incorporated by reference to Exhibit
10(r) of the 1997 10-K).

10(s) Employment Agreement, dated January 1, 1998, between the
Company and Richard Burris (incorporated by reference to
Exhibit 10(s) of the 1997 10-K).

10(t) Change of Control Agreement, dated January 1, 1998, between the
Company and Richard Burris (incorporated by reference to
Exhibit 10(t) of the 1997 10-K).

10(u) Manufacturing Agreement, dated September 30, 1997, between
AlliedSignal, Inc. and Mykotronx, Inc. (incorporated by
reference to Exhibit 10(u) of the 1998 10-K).

10(v) Development Agreement, dated September 30, 1997, between
AlliedSignal, Inc. and Mykotronx, Inc. (incorporated by
reference to Exhibit 10(v) of the 1998 10-K).

10(w) Agreement for Design and Product Purchase, dated September 4,
1997, between IBM Microelectronics and Rainbow Technologies,
Inc. and Mykotronx, Inc. (incorporated by reference to Exhibit
10(w) of the 1998 10-K).

10(x) Leases for premises at 357, 359, and 371 Van Ness Way,
Torrance, California, dated September 8, 1993, September 25,
1996 and October 2, 1997, respectively, between Surf Management
Associates, a California limited partnership, and Mykotronx,
Inc., a California Corporation (incorporated by reference to
Exhibit 10(x) of the 1999 Form 10-K).

10(y) Lease for premises at 111 West Ocean Boulevard, Long Beach,
California, between Stevens Creek Associates, a California
general partnership, and the Company (incorporated by reference
to Exhibit 10(y) of the 1999 Form 10-K).

10(z) Lease for premises at 8 Hughes, Irvine, California, between
Alton Irvine Partners, LLC, a California limited liability
company, and the Company (incorporated by reference to Exhibit
10(z) of the 2000 Form 10-K).

10(aa) 2000 Incentive Stock Option Plan (incorporated by reference to
Rainbow's Registration Statement on Form S-8 filed under the
Securities Act of 1933).

10(bb) Asset Purchase Agreement, dated December 29, 2000, between
Kasten Chase Applied Research Limited and Mykotronx, Inc.,
(incorporated by reference to Exhibit 11(b) of the 2000 Form
10-K).

10(cc) 2001 Nonstatutory Stock Option Plan (incorporated by reference
to Rainbow's Registration Statement on Form S-8 filed
under Securities Act of 1933).

21 List of Rainbow's wholly-owned subsidiaries.

23 Consent of Independent Auditors.

(b) Reports on Form 8-K

No reports on Form 8-K have been filed during the three months ended December
31, 2001.

21

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.

RAINBOW TECHNOLOGIES, INC.

By: /s/ WALTER W. STRAUB
--------------------------------
Walter W. Straub

Date: March 28, 2002

Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

Signature Title Date
--------- ----- ----

/s/ WALTER W. STRAUB President, Chief Executive March 29, 2002
- ------------------------------ Officer, and Chairman
Walter W. Straub of the Board

/s/ PATRICK E. FEVERY Vice President and March 29, 2002
- ------------------------------ Chief Financial Officer
Patrick E. Fevery

/s/ ALAN K. JENNINGS Director March 29, 2002
- ------------------------------
Alan K. Jennings

/s/ RICHARD P. ABRAHAM Director March 29, 2002
- ------------------------------
Richard P. Abraham

/s/ MARVIN HOFFMAN Director March 29, 2002
- ------------------------------
Marvin Hoffman

/s/ FREDERICK M. HANEY Director March 29, 2002
- ------------------------------
Frederick M. Haney

22

RAINBOW TECHNOLOGIES, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULE
For The Year Ended December 31, 2001

Page
----
Report of Independent Auditors............................................ F-2
Consolidated Balance Sheets............................................... F-3
Consolidated Statements of Operations..................................... F-4
Consolidated Statements of Shareholders' Equity........................... F-5
Consolidated Statements of Cash Flows..................................... F-6
Notes to Consolidated Financial Statements................................ F-7
Schedule II-- Consolidated Valuation and Qualifying Accounts.............. F-21

F-1

REPORT OF INDEPENDENT AUDITORS

Board of Directors
Rainbow Technologies, Inc.

We have audited the accompanying consolidated balance sheets of Rainbow
Technologies, Inc. as of December 31, 2001 and 2000, and the related
consolidated statements of operations, shareholders' equity, and cash flows for
each of the three years in the period ended December 31, 2001. Our audits also
included the financial statement schedule listed in the Index at Item 14(a).
These financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Rainbow
Technologies, Inc. at December 31, 2001 and 2000, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 2001, in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.

/s/ ERNST & YOUNG LLP

Orange County, California
February 26, 2002

F-2

RAINBOW TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

December 31, December 31,
2001 2000
------------- -------------

ASSETS
Current assets:
Cash and cash equivalents ............................................... $ 28,778,000 $ 19,458,000
Marketable available-for-sale securities ................................ 1,072,000 1,582,000
Marketable trading securities ........................................... 123,000 3,669,000
Accounts receivable, net of allowance for doubtful accounts
of $1,858,000 and $1,460,000 in 2001 and 2000, respectively .......... 24,492,000 40,710,000
Inventories ............................................................. 20,711,000 30,395,000
Income tax receivable ................................................... 1,844,000 7,444,000
Deferred income taxes ................................................... 13,901,000 5,862,000
Unbilled costs and fees ................................................. 2,227,000 1,039,000
Prepaid and other current assets ........................................ 1,634,000 3,325,000
------------- -------------
Total current assets ............................................ 94,782,000 113,484,000
Property, plant and equipment, at cost:
Equipment ............................................................... 20,838,000 18,467,000
Buildings ............................................................... 6,655,000 7,005,000
Furniture ............................................................... 2,810,000 1,645,000
Leasehold improvements .................................................. 2,946,000 1,837,000
------------- -------------
33,249,000 28,954,000
Less accumulated depreciation and amortization .......................... 17,336,000 13,266,000
------------- -------------
Net property, plant and equipment .................................. 15,913,000 15,688,000
Goodwill, net of accumulated amortization of $22,104,000 and
$15,549,000 in 2001 and 2000, respectively .............................. 15,638,000 21,524,000
Software development costs, net of accumulated amortization
of $11,218,000 and $4,411,000 in 2001 and 2000, respectively ............ 10,768,000 12,833,000
Product licenses, net of accumulated amortization of
$3,537,000 and $2,267,000 in 2001 and 2000, respectively ................ 4,030,000 4,900,000
Deferred income taxes...................................................... 2,421,000 --
Other assets .............................................................. 2,413,000 2,780,000
------------- -------------
$ 145,965,000 $ 171,209,000
============= =============

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable ........................................................ $ 9,929,000 $ 8,579,000
Accrued payroll and related expenses .................................... 5,063,000 8,671,000
Accrued restructuring costs.............................................. 3,130,000 --
Warranty reserve ........................................................ 2,417,000 386,000
Other accrued liabilities ............................................... 5,041,000 6,327,000
Long-term debt, due within one year ..................................... 211,000 223,000
Line of credit .......................................................... -- 3,129,000
------------- -------------
Total current liabilities ....................................... 25,791,000 27,315,000
Long-term debt, net of current portion .................................... 476,000 726,000
Deferred income taxes ..................................................... -- 2,718,000
Other liabilities ......................................................... 2,959,000 702,000
Commitments and contingencies
Shareholders' equity:
Common stock, $.001 par value, 55,000,000 shares authorized,
26,157,594 and 25,980,252 shares issued and outstanding in
2001 and 2000, respectively .......................................... 26,000 26,000
Additional paid-in capital .............................................. 56,885,000 55,689,000
Accumulated other comprehensive loss .................................... (1,539,000) (851,000)
Retained earnings ....................................................... 61,367,000 84,884,000
------------- -------------
Total shareholders' equity ...................................... 116,739,000 139,748,000
------------- -------------
$ 145,965,000 $ 171,209,000
============= =============

See accompanying notes.

F-3

RAINBOW TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31,

2001 2000 1999
------------- ------------- -------------

Revenues:
eSecurity Products ...................................... $ 56,388,000 $ 89,031,000 $ 67,046,000
Secure Communications Products .......................... 66,509,000 55,392,000 45,297,000
Spectria ................................................ 14,364,000 18,861,000 8,746,000
------------- ------------- -------------
Total revenues .................................. 137,261,000 163,284,000 121,089,000

Operating expenses:
Cost of eSecurity Products .............................. 38,021,000 27,174,000 19,385,000
Cost of Secure Communications Products .................. 51,125,000 42,270,000 38,410,000
Cost of Spectria ........................................ 8,948,000 11,394,000 6,347,000
Selling, general and administrative ..................... 46,245,000 46,580,000 32,970,000
Research and development ................................ 10,209,000 11,485,000 10,863,000
Goodwill amortization ................................... 2,787,000 3,174,000 2,438,000
Restructuring costs ..................................... 6,402,000 -- --
Goodwill impairment ..................................... 4,030,000 -- --
Asset impairment charge ................................. -- 2,173,000 --
------------- ------------- -------------
Total operating expenses ........................ 167,767,000 144,250,000 110,413,000

Operating income (loss) ................................... (30,506,000) 19,034,000 10,676,000

Interest income ........................................... 579,000 930,000 862,000
Interest expense .......................................... (141,000) (133,000) (191,000)
Gain (loss) on marketable trading securities .............. (3,546,000) 2,881,000 --
Write-off of long-term investment ......................... (1,206,000) -- --
Other income (expense), net ............................... 436,000 (423,000) 1,817,000
------------- ------------- -------------
Income (loss) before income taxes ......................... (34,384,000) 22,289,000 13,164,000
(Benefit) Provision for income taxes ...................... (10,867,000) 7,843,000 5,027,000
------------- ------------- -------------
Net income (loss) ......................................... $ (23,517,000) $ 14,446,000 $ 8,137,000
============= ============= =============

Net income (loss) per share:
Basic ................................................... $ (0.90) $ 0.58 $ 0.35
============= ============= =============
Diluted ................................................. $ (0.90) $ 0.52 $ 0.34
============= ============= =============

Shares used in computing net income (loss) per share:
Basic ................................................... 26,055,000 24,965,000 23,054,000
============= ============= =============
Diluted ................................................. 26,055,000 27,932,000 24,212,000
============= ============= =============

See accompanying notes.

F-4

RAINBOW TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Years Ended December 31, 2001, 2000 and 1999

Accumulated
Common Stock Additional Other
------------------------- Paid-in Comprehensive Retained
Shares Amount Capital Loss Earnings Total
----------- ----------- ----------- ----------- ----------- -----------

Balance, December 31, 1998 ......... 23,547,190 $ 24,000 $30,323,000 $ (447,000) $62,301,000 $92,201,000
Exercise of common stock options ... 627,038 -- 3,417,000 -- -- 3,417,000
Purchase and retirement of common
stock ............................ (1,119,748) (1,000) (7,974,000) -- -- (7,975,000)
Issuance of common stock ........... 313,478 -- 2,000,000 -- -- 2,000,000
Tax benefit of employee stock
options .......................... -- -- 836,000 -- -- 836,000
Other comprehensive loss:
Unrealized gain on marketable
securities (net of deferred
taxes of $39,000) .............. -- -- -- 63,000 -- 63,000
Translation adjustment (net of
deferred taxes of $484,000) .... -- -- -- (789,000) -- (789,000)
-----------
Total other comprehensive loss (726,000)
Net income ......................... -- -- -- -- 8,137,000 8,137,000
-----------
Comprehensive income ............... 7,411,000
----------- ----------- ----------- ----------- ----------- -----------
Balance, December 31, 1999 ......... 23,367,958 23,000 28,602,000 (1,173,000) 70,438,000 97,890,000
Exercise of common stock options ... 2,419,522 2,000 12,940,000 -- -- 12,942,000
Issuance of common stock ........... 192,772 1,000 999,000 -- -- 1,000,000
Tax benefit of employee stock
options .......................... -- -- 13,148,000 -- -- 13,148,000
Other comprehensive income:
Unrealized loss on marketable
securities (net of deferred
taxes of $317,000) ............. -- -- -- (475,000) -- (475,000)
Translation adjustment (net of
deferred taxes of $531,000) .... -- -- -- 797,000 -- 797,000
-----------
Total other comprehensive
income ..................... 322,000
Net income ......................... -- -- -- -- 14,446,000 14,446,000
-----------
Comprehensive income ............... 14,768,000
----------- ----------- ----------- ----------- ----------- -----------
Balance, December 31, 2000 ......... 25,980,252 26,000 55,689,000 (851,000) 84,884,000 139,748,000
Exercise of common stock options ... 177,342 -- 1,034,000 -- -- 1,034,000
Tax benefit of employee stock
options .......................... -- -- 162,000 -- -- 162,000
Other comprehensive income:
Unrealized gain on marketable
securities (net of deferred
taxes of $167,000) ............. -- -- -- 274,000 -- 274,000
Translation adjustment (net of
deferred taxes of $599,000) .... -- -- -- (962,000) -- (962,000)
-----------
Total other comprehensive
loss ....................... (688,000)
Net loss ........................... -- -- -- -- (23,517,000) (23,517,000)
-----------
Comprehensive loss.................. (24,205,000)
----------- ----------- ----------- ----------- ----------- -----------
Balance, December 31, 2001 ......... 26,157,594 $ 26,000 $56,885,000 $(1,539,000) $61,367,000 $116,739,000
=========== =========== =========== =========== =========== ===========

See accompanying notes.

F-5

RAINBOW TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,

2001 2000 1999
------------ ------------ ------------

Cash flows from operating activities:
Net income (loss) .......................................................... $(23,517,000) $ 14,446,000 $ 8,137,000
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Amortization ............................................................... 8,661,000 5,608,000 4,440,000
Depreciation ............................................................... 4,189,000 3,449,000 3,007,000
Change in deferred income taxes ............................................ (13,178,000) (1,948,000) (764,000)
Provision for doubtful accounts ............................................ 1,984,000 1,078,000 434,000
(Gain) loss from retirement of property, plant, and equipment .............. (15,000) 15,000 117,000
Minority interest in subsidiary's earnings (loss) .......................... 435,000 (14,000) (891,000)
Unrealized (gain) loss on marketable trading securities .................... 3,546,000 (2,881,000) --
Restructuring costs ........................................................ 4,773,000 -- --
Provision for excess and obsolete inventory ................................ 6,714,000 -- --
Warranty provision ......................................................... 1,907,000 -- --
Goodwill impairment ........................................................ 4,030,000 -- --
Write-off of long-term investment .......................................... 1,206,000 -- --
Write-off of capitalized and developed software ............................ 2,392,000 -- --
Foreign currency gain on repayment of loan to foreign subsidiary ........... (765,000) -- --
Asset impairment charge .................................................... -- 2,173,000 --
Tax benefit of exercise of common stock options ............................ 162,000 13,148,000 836,000
Changes in operating assets and liabilities:
Accounts receivable ...................................................... 12,818,000 (14,909,000) (8,883,000)
Inventories .............................................................. 2,535,000 (18,325,000) (1,361,000)
Unbilled costs and fees .................................................. (1,188,000) 1,877,000 (176,000)
Prepaid expenses and other current assets ................................ 1,670,000 (902,000) (1,648,000)
Accounts payable ......................................................... 1,587,000 (48,000) 3,555,000
Accrued liabilities ...................................................... (4,558,000) 3,245,000 4,050,000
Billings in excess of costs and fees ..................................... (238,000) (195,000) 1,239,000
Income taxes ............................................................. 5,882,000 (7,630,000) (965,000)
------------ ------------ ------------
Net cash provided by (used in) operating activities .................. 21,032,000 (1,813,000) 11,127,000
Cash flows from investing activities:
Capitalized software development costs ..................................... (5,032,000) (8,484,000) (1,907,000)
Purchases of property, plant, and equipment ................................ (4,871,000) (4,895,000) (4,934,000)
Purchase of marketable securities .......................................... -- (409,000) --
Sale of marketable securities .............................................. -- -- 5,322,000
Other non-current assets ................................................... (806,000) 96,000 (906,000)
Cash paid for investment in DataSafe Technologies, China ................... (231,000) -- --
Net cash paid for acquisition of Systematic Systems Integration, Inc. ...... -- (2,756,000) (9,590,000)
Net cash paid for acquisition of InfoCal LLC ............................... -- (1,000,000) (2,965,000)
Investment by new partners in QM Technologies, Inc. ........................ -- -- 660,000
Net cash paid for acquisition of InfoSec Labs, Inc. ........................ -- -- (1,647,000)
------------ ------------ ------------
Net cash used in investing activities ................................ (10,940,000) (17,448,000) (15,967,000)
Cash flows from financing activities:
Exercise of common stock options ........................................... 1,034,000 12,942,000 3,417,000
Borrowings (repayments) on line of credit .................................. (3,129,000) (2,871,000) 6,000,000
Repayment of long-term debt ................................................ (211,000) (224,000) (306,000)
Purchase and retirement of common stock .................................... -- -- (7,974,000)
------------ ------------ ------------
Net cash provided by (used in) financing activities .................. (2,306,000) 9,847,000 1,137,000
Effect of exchange rate changes on cash ...................................... 1,534,000 2,163,000 512,000
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents ......................... 9,320,000 (7,251,000) (3,191,000)
Cash and cash equivalents at beginning of year ............................... 19,458,000 26,709,000 29,900,000
------------ ------------ ------------
Cash and cash equivalents at end of year ..................................... $ 28,778,000 $ 19,458,000 $ 26,709,000
============ ============ ============
Supplemental disclosure of cash flow information:
Income taxes paid .......................................................... $ 1,695,000 $ 2,161,000 $ 1,807,000
Interest paid .............................................................. 97,000 288,000 182,000

See accompanying notes.

F-6

RAINBOW TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001

1. Summary of Significant Accounting Policies

General

Rainbow Technologies, Inc. (the Company) develops, manufactures, programs
and markets software and internet security products which prevent the
unauthorized use of intellectual property, including software programs and
provides privacy and security for network communications; develops and
manufactures secure communication products for satellite communications; and
provides customized eBusiness consulting services. The accompanying financial
statements consolidate the accounts of the Company and its wholly-owned
subsidiaries. All significant intercompany balances and transactions have been
eliminated. Certain amounts previously reported have been reclassified to
conform with the 2001 presentation.

Share amounts for all years presented have been adjusted to reflect the
impact of a two-for-one stock split effective October 9, 2000. In addition,
during fiscal 2000 the number of common stock shares authorized for issuance was
increased from 20,000,000 to 55,000,000.

In the third quarter of 2001, the Company created Rainbow eSecurity, a new
division focusing on the commercial security industry which combines all of the
desktop, software security and internet and network infrastructure security
solutions into a single business unit. Rainbow eSecurity was created through the
consolidation of the Company's Digital Rights Management (DRM) and iVEA
Operations. In connection with this reorganization, the Company recorded
restructuring charges of $6,402,000 (see Note 12 to Notes to Consolidated
Financial Statements).

Use of Estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in United States requires management to make
estimates and assumptions that affect the amounts reported in the accompanying
financial statements. Actual results could differ from those estimates.
Significant estimates made in preparing these financial statements include the
allowance for doubtful accounts, the reserve for excess and obsolete inventory,
goodwill valuations, accrued warranty costs, restructuring costs, the valuation
allowance for deferred tax assets and total estimated contract costs associated
with billed and unbilled contract revenue.

Cash Equivalents

The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents.

Marketable Securities

All investment securities are considered to be either trading or
available-for-sale and are carried at fair value. There were no securities
classified as trading for the year ended December 31, 1999. Management
determines classification at the time of purchase and re-evaluates its
appropriateness at each balance sheet date. The Company's marketable securities
consist of tax-exempt and other debt instruments that bear interest at variable
rates and equity securities. As of December 31, 2001, gross unrealized losses on
trading securities were $3,546,000 while gross unrealized gains were $2,881,000
as of December 31, 2001. Gross unrealized gains (losses) on available for sale
securities were $441,000, ($902,000) and $124,000 for the years ended December
31, 2001, 2000 and 1999, respectively. There were no realized gains (losses) for
the year ended December 31, 2001, while realized gains were $186,000 for the
year ended December 31, 2000. There were no material realized gains or losses
for the year ended December 31, 1999. The cost of securities sold is based on
the specific identification method.

In January 2002, $800,000 of the Company's available-for-sale fixed income
securities were sold.

Software Development Costs

Statement of Financial Accounting Standards No. 86, "Accounting for the
Costs of Computer Software to be Sold, Leased or Otherwise Marketed," requires
capitalization of certain software development costs subsequent to the
establishment of technological feasibility. Based upon the Company's product
development process, technological feasibility is established upon completion of
a working model. Amortization of capitalized software development costs
commences when the products are available for general release to customers and
are determined using the straight-line method over the expected useful lives of
the respective products.

F-7

Amortization of computer software development costs for the years ended
December 31, 2001, 2000 and 1999 amounted to $6,627,000, $1,422,000 and
$588,000, respectively. At September 30, 2001, the Company wrote off $2,392,000
of previously capitalized software development costs which were determined to be
obsolete.

Inventories

Inventoried costs relating to long-term contracts are stated at actual
production cost, including pro-rata allocations of factory overhead and general
and administrative costs incurred to date, reduced by amounts identified with
revenue recognized on units delivered. The costs attributed to units delivered
under such long-term contracts are based on the estimated average cost of all
units expected to be produced.

Inventories other than inventoried costs relating to long-term contracts
are stated at the lower of cost (first-in, first-out basis) or market.

Property, Plant and Equipment

Additions to property, plant, equipment and leasehold improvements are
recorded at cost and depreciated on the straight-line method over their
estimated useful lives as follows:

Buildings.......................... 31 years
Furniture.......................... 3 to 6 years
Equipment.......................... 3 to 7 years
Leasehold improvements............. Term of lease

Goodwill, Intangible Assets, and Other Long-Lived Assets

Goodwill and intangible assets consisting of product licenses and patents
are amortized using the straight-line method over seven to ten years. Goodwill
represents the excess of purchase price over the estimated fair value of assets
acquired.

The Company evaluates the recoverability of its long-lived assets,
including goodwill and intangible assets, in accordance with Statement of
Financial Accounting Standards No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of", which requires a
review for impairment on long-lived assets used in operations when indicators of
impairment are identified, such as technology obsolescence, reductions in demand
or economic slowdowns in the Company's industry segments. Reviews are performed
to determine whether the carrying value of assets is impaired, based on
comparison to undiscounted future cash flows. If this comparison indicates
impairment, the impaired asset is written-down to fair value, using a discounted
cash flow analysis. Impairment is based on the excess of the carrying amount
over the fair value of those assets.

At September 30, 2001, the Company recorded a goodwill impairment charge of
$4,030,000 relating to its eSecurity (Wyatt River Software $1,491,000) and
Spectria (Infosec Labs $2,539,000) industry segments (see Note 12).

The evaluation of the recoverability of goodwill is significantly affected
by management's estimates of future operating cash flows from the acquired
businesses to which the goodwill relates. If, in future periods, estimates of
the present value of future operating cash flows decrease, the Company would be
required to further write-down the goodwill, intangible assets, and other
long-lived assets. Any such write-down could have a material adverse effect on
the Company's consolidated financial position and results of operations. The
Company will closely monitor its remaining goodwill, intangible assets, and
other long-lived assets.

At June 30, 2000, the Company performed a review for impairment of the
long-lived assets related to QMT. Based on its evaluation, the Company
determined that all of the long-lived assets related to QMT were fully impaired
and, as a result, recorded an impairment charge of $2,173,000. Effective July 1,
2000, QMT is accounted for on the equity method as the company's ownership
percentage decreased below fifty percent.

Other Assets

Other assets primarily represent investments in early stage companies that
are accounted for on the cost basis. The Company periodically reviews these
investments for other-than-temporary declines in fair value and writes down
investments to their fair value when an other-than-temporary decline has
occurred based on the specific identification method. The Company generally
believes an other-than-temporary decline has occurred when the fair value of the
investment is below the carrying value for two consecutive quarters, absent
evidence to the contrary.

At September 30, 2001, the Company determined that the carrying value of
one of Spectria's long-term investments became fully impaired. As a result of
the downturn in economic conditions. Accordingly, the Company recorded a pre-tax
charge of $1,206,000 to fully write-off the investment.

F-8

Revenue Recognition

eSecurity

The Company recognizes revenues from product sales at the time of shipment.
Provision is currently made for estimated product returns which may occur under
programs the Company has with certain of its distributors.

Secure Communications Products

Catalog product revenues and revenues under certain fixed-price contracts
calling for delivery of a specified number of units are recognized as deliveries
are made. Revenues under cost-reimbursement contracts are recognized as costs
are incurred and include estimated earned fees in the proportion that costs
incurred to date bear to total estimated costs. Certain contracts are awarded on
a fixed-price incentive fee basis. Incentive fees on such contracts are
considered when estimating revenues and profit rates and are recognized when the
amounts can reasonably be determined. The costs attributed to units delivered
under fixed-price contracts are based on the estimated average cost per unit at
contract completion. Profits expected to be realized on long-term contracts are
based on total revenues and estimated costs at completion. Revisions to contract
profits are recorded in the accounting period in which the revisions are known.
Estimated losses on contracts are recorded when identified. For research and
development and other cost-plus-fee type contracts, the Company recognizes
contract earnings using the percentage-of-completion method. The estimated
contract revenues are recognized based on percentage-of-completion as determined
by the cost-to-cost basis whereby revenues are recognized ratably as contract
costs are incurred.

Spectria

The Company recognizes revenues from eBusiness consulting fees as services
are performed on a time and materials basis.

Warranty

The Company generally warrants its products for one year. An estimate of
the amount required to cover warranty expense on products sold is charged
against income at the time of sale.

Advertising

The Company expenses the costs of advertising as incurred. Advertising
expense was $3,246,000, $3,381,000 and $3,709,000 for 2001, 2000 and 1999,
respectively.

Shipping and Handling Costs

The Company's shipping and handling costs are included in cost of sales.

Research and Development

Expenditures for research and development are expensed as incurred.

F-9

Income Taxes

Deferred taxes are provided for items recognized in different periods for
financial and tax reporting purposes in accordance with Financial Accounting
Standards Board Statement No. 109, "Accounting For Income Taxes."

Foreign Currency

Balance sheet accounts denominated in foreign currency are translated at
exchange rates as of the date of the balance sheet and statement of operations
accounts are translated at average exchange rates for the period. Translation
gains and losses are accumulated as a separate component of Accumulated Other
Comprehensive Loss within Shareholders' Equity. The Company has adopted local
currencies as the functional currencies for its subsidiaries because their
principal economic activities are most closely tied to the respective local
currencies.

The Company does not engage in currency speculation. Foreign currency
transaction gains and losses are included in current operations and are not
material for years ended December 31, 2001, 2000, and 1999. There were no
foreign exchange contracts entered into during the years ended December 31,
2001, 2000 or 1999.

Stock Option Plans

The Company follows the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS No. 123) and, accordingly, accounts for its stock-based
compensation plans using the intrinsic value method under Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related
interpretations.

Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing income (loss)
available to common shareholders by the weighted-average number of common shares
outstanding for the period. Diluted earnings per share reflects the assumed
conversion of all dilutive securities, consisting of employee stock options.
Common equivalent shares of 6,502,035 for the year ended December 31, 2001 have
been excluded from diluted earnings (loss) per share as the effect would be
antidilutive.

Concentrations of Business and Credit Risk

Financial instruments which potentially subject the Company to credit risk
consist principally of trade receivables and interest bearing investments. The
Company performs on-going credit evaluations of its customers and generally does
not require collateral. The Company maintains adequate reserves for potential
losses and such losses, which have historically been minimal (excluding the
third quarter charge of $1.6 million), have been included in management's
estimates. The Company places substantially all of its interest bearing
investments with major financial institutions and, by policy, limits the amount
of credit exposure to any one financial institution.

The Company sells the majority of its eSecurity Products to software
developers and wholesale distributors throughout North America, Europe and Asia
Pacific.

The majority of the Company's Secure Communications Products are sold to
the U.S. Government (see Note 3). The U.S. Government accounted for
approximately 26%, 33%, and 25% of consolidated revenues in 2001, 2000, and
1999, respectively. In addition, approximately 38% and 30% of consolidated
accounts receivable and 44% and 79% of unbilled costs and fees at December 31,
2001 and 2000, respectively, were related to the U.S. Government.

For its Secure Communications Products, the Company's manufacturing
operations include the testing of Application Specific Integrated Circuits
("ASICs") and the assembly and testing of its satellite ground units and network
communications products. The Company has specific encryption technology embedded
into ASIC chip that are fabricated to the Company's specifications by ASIC chip
manufacturers. The Company currently has relationships with four such ASIC
circuit manufacturers. These ASIC are processed to the specifications of the
U.S. Government and the Company. Any interruption in the availability of these
ASIC circuits could have a material adverse effect on the consolidated results
of operations and cash flows of the Company.

The Company currently has manufacturing relationships with two suppliers to
manufacture the Company's principal Secure Communications Product. Any
interruption in the availability of this product would have a material adverse
effect on the consolidated results of operations and cash flows of the Company.
Having two sources mitigates the risk of any delivery shortfall resulting from
one source having production difficulties. One manufacturing agreement expires
in March 2003, the other manufacturing agreement expires in February 2004.

F-10

For the Sentinel Superpro product, the Company currently has one supplier
of the custom ASIC chip used for some of its eSecurity product lines and this
supplier has multiple foundries available to produce the ASIC chip. If the
supplier is unable to fulfill the Company's requirements, the Company may
experience an interruption in the production of its products until an
alternative source of supply is developed. The Company maintains a six-month
inventory of these ASIC chips in order to limit the potential for such an
interruption. The Company believes that there are a number of companies capable
of commencing the manufacture of these ASIC chips within six months of such an
interruption.

Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statements of Financial Accounting Standards ("SFAS") No. 141 "Business
Combinations" and No. 142 "Goodwill and other Intangible Assets." SFAS No. 141
addresses financial accounting and reporting for a business combination and
requires all business combinations to be accounted for using the purchase
method. SFAS No. 141 is effective for any business combinations initiated after
June 30, 2001. SFAS No. 142, effective for the Company January 1, 2002,
addresses the initial recognition and measurement of goodwill and other
intangible assets acquired in a business combination. Goodwill and other
intangible assets with indefinite lives will no longer be amortized but instead
be subject to impairment tests at least annually. The Company will apply the new
rules on accounting for goodwill and other intangible assets from prior
acquisitions beginning in the first quarter of 2002. Application of the
non-amortization provisions of SFAS No. 142 is estimated to result in a decrease
of goodwill amortization of approximately $2 million per year. The Company will
perform the first of the required impairment tests of goodwill and
indefinite-lived intangible assets under the new rules during 2002. The Company
has not yet determined the effect these tests will have on its consolidated
results of operations and financial condition.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets". SFAS No. 144, effective for the
Company January 1, 2002, supersedes FASB Statement No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,"
and the accounting and reporting provisions of APB Opinion No. 30, "Reporting
the Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions," for the disposal of a segment of a business (as previously
defined in that opinion). SFAS No. 144 requires that one accounting model be
used for long-lived assets to be disposed of by sale, whether previously held
and used or newly acquired, and broadens the presentation of discontinued
operations to include more disposal transactions than were included under the
previous standards. SFAS No. 144 is expected to have no impact upon initial
adoption.

2. Acquisitions

On October 22, 1999, the Company completed the acquisition of InfoCal LLC
("InfoCal"). InfoCal creates collaborative intranet/extranet applications,
knowledge portals and distance learning applications and specializes in
messaging strategy migration and implementation. The initial transaction value
was $3.5 million, including $3.0 million paid in cash and 73,060 split adjusted
shares of Rainbow common stock valued at $500,000. In fiscal 2000, an additional
$1.0 million was paid out related to an earn-out provision. This acquisition was
accounted for using the purchase method of accounting. Approximately $4.5
million has been allocated to goodwill and is being amortized on a straight-line
basis over ten years. Results of operations for InfoCal are included in the
Company's consolidated results of operations beginning on October 22, 1999.

On September 16, 1999, the Company completed the acquisition of InfoSec
Labs, Inc. ("InfoSec"). InfoSec has core competency in both enterprise and
internet security solutions is renowned for its security assessment and
education programs. The total transaction value was $3.1 million, including $1.6
million paid in cash and 240,418 split adjusted shares of Rainbow common stock
valued at $1.5 million. This acquisition was accounted for using the purchase
method of accounting. Approximately $3.1 million was allocated to goodwill and
is being amortized on a straight-line basis over ten years. Results of
operations for InfoSec are included in the Company's consolidated results of
operations beginning on September 16, 1999 (See Note 1).

On May 12, 1999, the Company completed the acquisition of Systematic
Systems Integration ("Systematic") for an initial purchase price of $9.6 million
in cash with an additional cash payment of $1.5 million accrued at December 31,
1999 and paid in January 2000. An additional $1.3 million was paid out in fiscal
2000 related to an earn-out provision based upon revenues. This acquisition was
accounted for using the purchase method of accounting. The entire purchase price
and earn-out payments have been allocated to goodwill. The goodwill is being
amortized on a straight-line basis over ten years. Systematic is a
California-based eCommerce integration services firm that enables companies to
seamlessly integrate diverse software and hardware platforms, communication
systems and internet technologies. Results of operations for Systematic are
included in the Company's consolidated results of operations beginning on May
12, 1999.

3. Government Contracts

The Company is both a prime contractor and subcontractor under fixed-price
and cost reimbursement contracts with the U.S. Government (Government). At the
commencement of each contract or contract modification, the Company submits
pricing proposals to the Government to establish indirect cost rates applicable

F-11

to such contracts. These rates, after audit and approval by the Government, are
used to settle costs on contracts completed during the previous year.

To facilitate interim billings during the performance of its contracts, the
Company establishes provisional billing rates, which are used in recognizing
contract revenue and contract accounts receivable. The provisional billing rates
are adjusted to actual at year-end and are subject to adjustment after
Government audit.

The Company has unbilled costs and fees related to government contracts of
$2,168,000 and $1,039,000 at December 31, 2001 and 2000, respectively. Based on
the Company's experience with similar contracts in recent years, the unbilled
costs and fees are expected to be collected within one year.

4. Inventories

Inventories consist of the following at December 31:

2001 2000
------------ ------------

Raw materials ............................................... $ 14,016,000 $ 11,896,000
Work in process ............................................. 2,643,000 2,538,000
Finished goods .............................................. 5,883,000 11,239,000
Inventoried costs relating to long-term contracts, net
of amounts attributed to revenues recognized to date ...... 4,569,000 5,499,000
Reserve for excess and obsolete inventory ................... (6,400,000) (777,000)
------------ ------------
$ 20,711,000 $ 30,395,000
============ ============

General and administrative expenses in inventory at December 31, 2001 and
2000 were $258,000 and $411,000, respectively.

5. Long-Term Debt

Long-term debt consists of a note payable to a bank with principal and
interest at 11.6%, payable quarterly in French Francs. The note matures in
January 2005 and is secured by a building with a net book value of $3,723,000 at
December 31, 2001. Annual principal payments are as follows:

2002......................... $ 211,000
2003......................... 211,000
2004......................... 211,000
2005......................... 54,000
----------
$ 687,000
==========

6. Line of Credit

The Company had a $5 million revolving line of credit which expired on June
7, 2001. At December 31, 2000, there was $3.1 million outstanding under the line
of credit which was repaid in January 2001.

7. Accumulated Other Comprehensive Loss

Accumulated other comprehensive loss is comprised of unrealized foreign
currency translation losses of $1,272,000, and $310,000, net of deferred taxes,
at December 31, 2001 and 2000, respectively, and unrealized losses on marketable
securities of $267,000 and $541,000, net of deferred taxes, at December 31, 2001
and 2000, respectively.

8. Fair Value of Financial Instruments

The Company's financial instruments consist principally of cash, marketable
securities, receivables, unbilled costs and fees, payables, long-term
investments, and borrowings. The Company believes all of the financial
instruments' recorded values approximate current fair values, as a result of the
short-term nature of these instruments, except as noted in the table below.

F-12

The estimated fair value of the long-term debt is based upon current market
information and an appropriate valuation methodology.

2001 2000
------------------------- -------------------------
Carrying Estimated Carrying Estimated
Value Fair Value Value Fair Value
---------- ---------- ---------- ----------

Long-term debt .................. $ 687,000 $ 754,000 $ 949,000 $ 1,076,000

9. Commitments and Contingencies

The Company has purchase commitments with various vendors arising out of
the normal course of business for approximately $20,729,000 as of December 31,
2001. These purchase commitments have terms less than one year.

Annual obligations under non-cancelable operating leases are as follows:

2002......................... $ 2,701,000
2003......................... 2,705,000
2004......................... 2,697,000
2005......................... 1,887,000
2006 and thereafter.......... 66,000
------------
$ 10,056,000
============

Rent expense charged to operations for the years ended December 31, 2001,
2000, and 1999 were $3,238,000, $2,261,000 and $1,743,000, respectively.

Litigation

In September 1998, a patent infringement action was filed against the
Company by Globetrotter, Inc., alleging that certain of the Company's products
infringe patents owned by Globetrotter. The complaint seeks unspecified monetary
damages and a permanent injunction banning the use of the products alleged to
infringe the Globetrotter patents. On September 24, 2001, the District Court
granted partial summary judgment in favor of the Company as it relates to
allegations by Globetrotter. The Company has filed a counterclaim alleging
antitrust and unfair competition and has been vigorously prosecuting their
antitrust and other business tort claims. The counterclaims are presently set
for trail on September 10, 2002.

In July 1998, a patent infringement claim was filed against the Company by
Andrew Pickholtz, alleging that certain of the Company's products infringe
patents owned by Pickholtz. The complaint seeks unspecified monetary damages.
The Company filed a motion for summary judgment of noninfringement that was
decided in favor of the Company in December 2000. In January 2001, Mr. Pickholtz
filed a notice of appeal. After considering legal briefs filed by the Company
and by Mr. Pickholtz, the Court of Appeals for the Federal Circuit heard oral
arguments in the case on November 7, 2001, but as of February 28, 2002 has not
ruled on the appeal. The Company continues to believe the claims are without
merit as found by the trial court and intends to continue to vigorously defend
against any infringement claims made by Mr. Pickholtz.

The Company is also involved in other legal proceedings and claims arising
in the ordinary course of business. The Company does not believe that any
liabilities related to the legal proceedings to which it is a party are likely
to be, individually or in the aggregate, material to the Company's consolidated
financial condition, results of operations or cash flows.

10. Stock Option Plans

The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" (APB 25) and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under SFAS
No. 123 requires use of option valuation models that were not developed for use
in valuing employee stock options. Under APB 25, because the exercise price of
the Company's employee stock options equals the market price of the underlying
stock on the date of grant, no compensation expense is recognized.

As of December 31, 2001, the total number of shares of common stock
reserved for issuance under the existing stock option plans was 8,605,317 and
the total number of options available for grant was 2,103,282. Under the plans,
non-statutory or incentive stock options may be granted to key employees and

F-13

individuals who provide services to the Company. Options become exercisable and
expire at the discretion of the Board of Directors, although the plan specifies
that no options shall be exercisable prior to 12 months from the date of grant
and all options expire ten years from the date of grant. Options generally vest
over 4 years.

The following is a summary of changes in options outstanding pursuant to
the plans for the years ended December 31:

2001 2000 1999
-------------------------- --------------------------- ---------------------------
Weighted Weighted Weighted
Average Average Average
Options Exercise Price Options Exercise Price Options Exercise Price
---------- -------------- ---------- -------------- ---------- --------------

Outstanding -- beginning
of year ................................ 5,591,196 $ 8.97 6,395,910 $ 5.62 5,559,738 $ 5.49
Granted ................................ 2,022,550 3.95 2,022,600 15.04 1,999,450 6.06
Exercised .............................. (177,342) 5.83 (2,419,522) 5.34 (627,038) 5.45
Forfeited and expired .................. (934,369) 9.52 (407,792) 7.88 (536,240) 6.19
---------- ------ ---------- ------ ---------- ------
Outstanding -- end
of year ................................ 6,502,035 $ 7.43 5,591,196 $ 8.97 6,395,910 $ 5.62
========== ========== ==========

Exercisable at end of year ............... 3,513,029 $ 7.50 2,229,688 $ 5.57 3,266,646 $ 5.26
Weighted-average fair value of
options granted during the year ........ $ 2.55 $ 8.64 $ 2.78

The following table summarizes information about stock options outstanding
at December 31, 2001:

Outstanding Exercisable
------------------------------------------------ ----------------------------
Weighted Average Weighted Weighted
Range of Number Remaining Average Number Average
Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
--------------- ----------- ---------------- -------------- ----------- --------------

$ 3.30 to $ 4.71 1,960,188 8.3 $ 3.71 370,762 $ 3.92
5.04 to 7.50 2,977,323 5.8 5.92 2,401,502 5.89
7.88 to 10.81 309,819 7.0 10.48 200,249 10.32
15.97 to 16.94 1,254,705 8.0 16.06 540,516 16.09

The weighted average remaining contractual life of stock options
outstanding at December 31, 2001, 2000, and 1999 was 7.0 years, 7.8 years and
7.4 years, respectively.

Pro forma information regarding net income (loss) and earnings (loss) per
share is required by SFAS 123 and has been determined as if the Company had
accounted for its employee stock options under the fair value method of that
statement. The fair value for these options was estimated at the date of grant
using a Black-Scholes option pricing model with the following weighted average
assumptions for 2001, 2000 and 1999: risk free interest rate of 4.0% for 2001,
6.1% for 2000 and 5.6% for 1999; dividend yield of 0% for 2001, 2000, and 1999;
volatility factor of the expected market price of the Company's common stock of
.87 for 2001, 0.70 for 2000 and 0.51 for 1999; and a weighted-average life of
the option of 4.0 years for 2001, 2000, and 1999.

The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

F-14

For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
pro forma information follows:

2001 2000 1999
-------------- ------------ ------------

Pro forma net income (loss) ............ $ (27,984,000) $ 11,421,000 $ 6,568,000
Pro forma earnings (loss) per share:
Basic ................................ $ (1.07) $ .46 $ .29
Diluted .............................. $ (1.07) $ .41 $ .27

11. Shareholder's Rights Plan

In July 1997, the Board of Directors of the Company adopted a Shareholder's
Rights Plan. In doing so, the Board of Directors declared a dividend of one
right (a "Right") for each outstanding share of the Company's Common Stock, as
of August 5, 1997 and subsequently with respect to each subsequent issuance of a
share of Common Stock. Following a "Distribution Date," each holder of a Right
is entitled to purchase, at a stated purchase price, shares of the Company's
Common Stock or other property having a value equal to two times the purchase
price. A Distribution Date will occur on the earlier of (i) the tenth day after
a public announcement that a person other than the Company or its affiliates has
acquired, or obtained the right to acquire, beneficial ownership of 15% or more
of the outstanding Common Stock (such person thereby becoming an "Acquiring
Person"), or (ii) the tenth business day after the date of the commencement of,
or first public announcement of the intent of any person to commence a tender or
exchange offer, the consummation of which would result in such person becoming
an Acquiring Person. Following a Distribution Date, the Rights of an Acquiring
Person are null and void and not exercisable. Outstanding Rights are redeemable
by the Board of Directors at any time prior to a Distribution Date at a
redemption price of $0.01 per Right. The Rights will expire at the close of
business on August 5, 2002, unless earlier exercised by the holder or redeemed
by the Company.

12. Restructuring and Other Charges

In the third quarter 2001, the Company restructured and consolidated its
Digital Rights Management (DRM) and iVEA operations (eSecurity segment),
resulting in a net staff reduction of 97 employees across all employee groups
primarily in the U.S. and recorded restructuring charges of $6,402,000. Also
during the third quarter, other charges aggregating $19,688,000 were recorded.

The following table summarizes the Company's restructuring costs and activities
in the restructuring reserves (in thousands):

FACILITIES
AND
EQUIPMENT SEVERANCE Total
--------- --------- ---------
Charged to costs and expenses $ 5,271 $ 1,131 $ 6,402

Cash payments (698) (931) (1,629)
--------- --------- ---------

Restructuring balance, December 31, 2001 $ 4,573 $ 200 $ 4,773
========= ========= =========

The current portion of the restructuring reserve of $3,130,000 relating to
office space reduction and severance is recorded in other accrued liabilities
while the long-term portion of the reserve of $1,643,000 is recorded in other
liabilities. Exit activities are anticipated to continue through 2002 with lease
obligations currently expiring in 2005.

The following table summarizes the other charges recorded in the third quarter
of 2001 (in thousands):

COST SELLING,
OF GENERAL AND GOODWILL OTHER
REVENUES ADMINISTRATIVE IMPAIRMENT EXPENSE Total
----------- -------------- ----------- ----------- -----------

Reserve for excess and obsolete inventory $ 7,414 $ 7,414
Write-off of capitalized software 2,392 2,392
Warranty reserve 1,782 1,782
Provision for bad debts 1,612 1,612
Goodwill impairment 4,030 4,030
Write-off of long-term investment 1,206 1,206
Foreign currency transaction loss 1,252 1,252
----------- -------------- ----------- ----------- -----------

Total third quarter 2001 other charges $ 11,588 $ 1,612 $ 4,030 $ 2,458 $ 19,688
=========== ============== =========== =========== ===========

F-15

13. Income Taxes

The provision (benefit) for income taxes consists of the following for the
years ended December 31:

2001 2000 1999
----------- ----------- -----------

Current:
Federal ................... $ 1,733,000 $ 5,498,000 $ 4,227,000
State ..................... (4,000) 2,988,000 716,000
Foreign ................... 582,000 1,305,000 848,000
------------ ----------- -----------
2,311,000 9,791,000 5,791,000
Deferred:
Federal ................... (11,591,000) (385,000) (813,000)
State ..................... (1,587,000) (1,563,000) 49,000
Foreign ................... -- -- --
------------ ----------- -----------
(13,178,000) (1,948,000) (764,000)
------------ ----------- -----------
$(10,867,000) $ 7,843,000 $ 5,027,000
============ =========== ===========

A reconciliation of the statutory federal income tax provision (benefit) to
the actual provision follows for the years ended December 31:

2001 2000 1999
------------ ----------- -----------

Statutory federal income tax expense .............. $(12,034,000) $ 7,801,000 $ 4,607,000
State taxes, net of federal benefit ............... (1,035,000) 926,000 569,000
Non-deductible amortization of goodwill ........... 1,737,000 486,000 431,000
Non-deductible subsidiary loss .................... -- 132,000 313,000
Effect of foreign operations, net ................. 668,000 (694,000) (1,217,000)
Valuation allowance ............................... -- (517,000) --
Research and experimentation credit ............... (245,000) (60,000) --
Municipal interest ................................ (13,000) (18,000) (22,000)
Other, net ........................................ 55,000 (213,000) 346,000
------------ ----------- -----------
$(10,867,000) $ 7,843,000 $ 5,027,000
============ =========== ===========

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 assets and liabilities
are as follows for the years ended December 31:

2001 2000
----------- -----------

Deferred tax assets:
Accruals and reserves not currently tax
deductible ............................................... $ 4,360,000 $ 2,602,000
Restructuring costs ......................................... 3,130,000 --
Contract revenue recognized for tax reporting purposes ...... 1,546,000 1,509,000
Foreign tax loss carryforwards .............................. 505,000 505,000
Tax credit carryforward ..................................... 1,625,000 479,000
Capital loss carryforward ................................... 372,000 448,000
Net operating loss carryforward ............................. 5,760,000 262,000
Cumulative translation adjustment ........................... 686,000 150,000
Book/tax basis difference in Wyatt River assets ............. 1,556,000 26,000
Contribution carryforward ................................... 154,000 --
----------- -----------
Total deferred tax assets ........................... 19,694,000 5,981,000

Deferred tax liabilities:
Accruals without tax effect ................................. (189,000) (119,000)
Tax depreciation ............................................ (750,000) (250,000)
State taxes ................................................. (972,000) (390,000)
Amortization of intangibles ................................. (1,461,000) (2,078,000)
----------- -----------
Total deferred tax liabilities ...................... (3,372,000) (2,837,000)
----------- -----------
Net deferred tax asset ........................................ $16,322,000 $ 3,144,000
=========== ===========

The Company currently has significant deferred tax assets, which are
subject to periodic recoverability assessments. There is no valuation allowance
provided against the deferred tax assets as the Company believes it is more
likely than not that these assets will be realized. This conclusion is based
upon the expectation of future taxable income and tax planning strategies.

At December 31, 2001, the Company has federal net operating loss
carryforwards of approximately $14,473,000 which begin to expire in 2020. In
addition, the Company is successor to net operating losses of approximately
$4,876,000 from the acquisition of Wyatt River Software which are subject to the
change of ownership provisions and are limited to approximately $204,000 per
year.

At December 31, 2001, the Company had a federal research and development
credit carryforward of approximately $699,000 which will begin to expire in
2018.

Utilization of the federal net operating loss and research and development
credit carryforwards could be limited in future years, if the Company were to
experience a greater than 50 percent change in ownership within a 3-year period
as defined in sections 382 and 383 of the United States Internal Revenue Code of
1986.

F-16

United States and foreign earnings before income taxes are as follows for
the years ended December 31:

2001 2000 1999
------------ ----------- -----------
United States .......... $(31,772,000) $16,827,000 $ 7,262,000
Foreign ................ (2,612,000) 5,462,000 5,902,000
------------ ----------- -----------
$(34,384,000) $22,289,000 $13,164,000
============ =========== ===========

The Company realized tax benefits of $162,000, $13,148,000, and $836,000 in
2001, 2000 and 1999, respectively, from the exercise of non-qualified stock
options and disqualifying disposition of incentive stock options.

14. Benefit Plans

At December 31, 2001, the Company sponsored two tax deferred defined
contribution plans for all eligible US employees. Under both plans, the employer
matches certain employee contributions. During the years ended December 31,
2001, 2000, and 1999, Company contributions under both Plans totaled
approximately $563,000, $586,000, and $453,000, respectively.

15. Industry Segments

The Company currently operates in three industry segments. The first
segment is the development and sale of devices which protect data and software
from unauthorized use, products that provide access control to computer
networks, Internet Websites and virtual private networks and products which
accelerate performance of security servers and network equipment (eSecurity
Products segment that was the Secure Software Distribution Products and Internet
Performance and Security segments combined in the prior year). The second
segment is the development and sale of information security products to provide
privacy and security for voice communication and data transmission (Secure
Communications Products segment that was the Information Security Products
segment in the prior year). The third segment provides services that enable
companies to integrate diverse software and hardware platforms (Spectria). All
intercompany transactions are accounted for on the same basis as those with
third-parties.

A summary of the Company's operations by industry segment follows:

Year Ended December 31, 2001
--------------------------------------------------------------------------------

Secure
eSecurity Communications Spectria Elimination Consolidated
------------- ------------- ------------- ------------- -------------

Revenues:
External customers .................. $ 56,388,000 $ 66,509,000 $ 14,364,000 $ -- $ 137,261,000
Intersegment ........................ -- 282,000 -- (282,000) --
Operating income (loss) ............... (38,215,000) 13,281,000 (5,572,000) -- (30,506,000)
Interest expense ...................... 119,000 -- 22,000 -- 141,000
Interest income ....................... 440,000 139,000 -- -- 579,000
Income tax provision (benefit) ........ (16,164,000) 5,297,000 -- -- (10,867,000)
Capital expenditures .................. 3,272,000 1,566,000 33,000 -- 4,871,000
Identifiable assets ................... 153,382,000 58,292,000 35,908,000 (101,617,000) 145,965,000
Significant non-cash items:
Changes in deferred taxes ........... (13,178,000 -- -- -- (13,178,000)
Reserve for excess and obsolete
inventory ......................... 6,400,000 -- -- -- 6,400,000
Warranty reserves.................... 2,075,000 342,000 -- -- 2,417,000
Provision for doubtful accounts
receivables ....................... 1,130,000 346,000 382,000 -- 1,858,000

Write-off of capitalized and
developed software................. 2,392,000 -- -- -- 2,392,000

Unrealized loss on marketable
trading securities ................ 3,546,000 -- -- -- 3,546,000
Depreciation and amortization ....... 7,634,000 2,618,000 2,598,000 -- 12,850,000
Restructuring costs ................. 5,830,000 -- 572,000 -- 6,402,000
Goodwill impairment ................. 1,491,000 -- 2,539,000 -- 4,030,000
Write-off of long-term investment ... -- -- 1,206,000 -- 1,206,000
Foreign currency transaction loss ... 1,252,000 -- -- -- 1,252,000

F-17

Year Ended December 31, 2000
--------------------------------------------------------------------------------

Secure
eSecurity Communications Spectria Elimination Consolidated
------------- ------------- ------------- ------------- -------------

Revenues:
External customers .............. $ 89,031,000 $ 55,392,000 $ 18,861,000 $ -- $ 163,284,000
Intersegment .................... -- 2,059,000 -- (2,059,000) --
Operating income (loss) ........... 9,602,000 12,243,000 (2,811,000) -- 19,034,000
Interest expense .................. 128,000 -- 5,000 -- 133,000
Interest income ................... 743,000 146,000 41,000 -- 930,000
Income tax provision .............. 2,885,000 4,958,000 -- -- 7,843,000
Capital expenditures .............. 3,547,000 541,000 807,000 -- 4,895,000
Identifiable assets ............... 223,708,000 43,945,000 44,107,000 (140,551,000) 171,209,000
Significant non-cash items:
Unrealized gain on marketable
trading securities ............ 2,881,000 -- -- -- 2,881,000
Changes in deferred taxes ....... (1,948,000) -- -- -- (1,948,000)
Depreciation and amortization ... 5,074,000 1,835,000 2,148,000 -- 9,057,000
Asset impairment charge ......... 2,173,000 -- -- -- 2,173,000
Provision for doubtful
accounts receivables .......... 1,117,000 -- 343,000 -- 1,460,000

Year Ended December 31, 1999
--------------------------------------------------------------------------------

Secure
eSecurity Communications Spectria Elimination Consolidated
------------- ------------- ------------- ------------- -------------

Revenues:
External customers ............. $ 67,046,000 $ 45,297,000 $ 8,746,000 $ -- $ 121,089,000
Intersegment ................... 95,000 1,869,000 -- (1,964,000) --
Operating income (loss) .......... 5,273,000 5,917,000 (514,000) -- 10,676,000
Interest expense ................. 177,000 3,000 11,000 -- 191,000
Interest income .................. 676,000 174,000 12,000 -- 862,000
Income tax provision ............. 2,810,000 2,217,000 -- -- 5,027,000
Capital expenditures ............. 2,638,000 1,661,000 635,000 -- 4,934,000
Identifiable assets .............. 120,174,000 32,165,000 22,956,000 (44,757,000) 130,538,000
Significant non-cash items:
Changes in deferred taxes ...... (764,000) -- -- -- (764,000)
Depreciation and amortization .. 5,062,000 1,530,000 855,000 -- 7,447,000

A summary of the Company's operations by geographic area follows:

For the Year Ended December 31, 2001
--------------------------------------------------------------------------------
United United
States Netherlands France Kingdom Europe
------------- ------------- ------------- ------------- -------------

Sales to unaffiliated
customers .......... $ 113,282,000 $ 7,532,000 $ 3,653,000 $ 3,563,000 $ 2,213,000
Transfers between
geographic areas ... 11,943,000 6,419,000 324,000 -- --
------------- ------------- ------------- ------------- -------------
Revenues ......... $ 125,225,000 $ 13,951,000 $ 3,977,000 $ 3,563,000 $ 2,213,000
============= ============= ============= ============= =============
Operating income
(loss) ............. $ (27,937,000) $ 2,350,000 $ (1,836,000) $ (2,129,000) $ (1,038,000)
Long-lived assets .... 78,661,000 21,353,000 6,006,000 1,047,000 88,000
Net assets ........... 116,827,000 22,710,000 (2,110,000) 3,909,000 3,989,000

For the Year Ended December 31, 2001
-----------------------------------------------

Asia-Pacific Elimination Consolidated
------------- ------------- -------------

Sales to unaffiliated
customers .......... $ 7,018,000 $ -- $ 137,261,000
Transfers between
geographic areas ... 398,000 (19,084,000) --
------------- ------------- -------------
Revenues ......... $ 7,416,000 $ (19,084,000) $ 137,261,000
============= ============= =============
Operating income
(loss) ............. $ 1,106,000 $ (1,022,000) $ (30,506,000)
Long-lived assets .... 1,276,000 (59,669,000) 48,762,000
Net assets ........... 4,308,000 (32,894,000) 116,739,000

For the Year Ended December 31, 2000
--------------------------------------------------------------------------------
United United
States Netherlands France Kingdom Europe
------------- ------------- ------------- ------------- -------------

Sales to unaffiliated
customers .......... $ 130,384,000 $ 13,521,000 $ 3,697,000 $ 4,736,000 $ 6,223,000
Transfers between
geographic areas ... 6,662,000 9,515,000 457,000 -- --
------------- ------------- ------------- ------------- -------------
Revenues ......... $ 137,046,000 $ 23,036,000 $ 4,154,000 $ 4,736,000 $ 6,223,000
============= ============= ============= ============= =============
Operating income
(loss) ............. $ 9,611,000 $ 12,082,000 $ (1,926,000) $ (412,000) $ (576,000)
Long-lived assets .... 92,755,000 18,016,000 7,171,000 1,044,000 493,000
Net assets ........... 137,531,000 27,423,000 7,046,000 4,566,000 917,000

For the Year Ended December 31, 2000
-----------------------------------------------

Asia-Pacific Elimination Consolidated
------------- ------------- -------------

Sales to unaffiliated
customers .......... $ 4,723,000 $ -- $ 163,284,000
Transfers between
geographic areas ... 365,000 (16,999,000) --
------------- ------------- -------------
Revenues ......... $ 5,088,000 $ (16,999,000) $ 163,284,000
============= ============= =============
Operating income
(loss) ............. $ 253,000 $ 2,000 $ 19,034,000
Long-lived assets .... 331,000 (62,085,000) 57,725,000
Net assets ........... 919,000 (38,654,000) 139,748,000

F-18

For the Year Ended December 31, 1999
--------------------------------------------------------------------------------
United United
States Netherlands France Kingdom Europe
------------- ------------- ------------- ------------- -------------

Sales to unaffiliated
customers ......... $ 94,379,000 $ 12,426,000 $ 4,644,000 $ 4,350,000 $ 2,844,000
Transfers between
geographic areas .. 4,126,000 6,627,000 629,000 -- --
------------- ------------- ------------- ------------- -------------
Revenues ........ $ 98,505,000 $ 19,053,000 $ 5,273,000 $ 4,350,000 $ 2,844,000
============= ============= ============= ============= =============
Operating income
(loss) ............ $ 2,213,000 $ 9,997,000 $ (634,000) $ 6,000 $ (771,000)
Long-lived assets ... 87,836,000 16,022,000 7,628,000 1,148,000 509,000
Net assets .......... 100,346,000 22,228,000 7,509,000 4,390,000 611,000

For the Year Ended December 31, 1999
-----------------------------------------------

Asia-Pacific Elimination Consolidated
------------- ------------- -------------

Sales to unaffiliated
customers ......... $ 2,446,000 $ -- $ 121,089,000
Transfers between
geographic areas .. 95,000 (11,477,000) --
------------- ------------- -------------
Revenues ........ $ 2,541,000 $ (11,477,000) $ 121,089,000
============= ============= =============
Operating income
(loss) ............ $ (75,000) $ (60,000) $ 10,676,000
Long-lived assets ... 162,000 (61,424,000) 51,881,000
Net assets .......... 646,000 (37,840,000) 97,890,000

Geographic information for Europe encompasses the Company's operations in
Germany and Russia while Asia-Pacific encompasses the Company's operations in
China, Taiwan, Australia, Japan, and India. In determining operating income for
each geographic area, sales and purchases between geographic areas have been
accounted for on the basis of internal transfer prices set by the Company.
Identifiable assets are those tangible and intangible assets used in operations
in each geographic area.

16. Supplementary Quarterly Consolidated Financial Data (unaudited)

March 31, June 30, September 30, December 31,
2001(1) 2001(1) 2001(1)(2)(3)(6) 2001(1)(6)
------------ ------------ ---------------- ------------

Revenues:
eSecurity Products ...................... $ 17,247,000 $ 16,406,000 $ 10,305,000 $ 12,430,000
Secure Communications Products .......... 18,648,000 17,137,000 14,855,000 15,869,000
Spectria ................................ 4,305,000 3,802,000 2,896,000 3,361,000
------------ ------------ ------------ ------------
Total revenues ................... $ 40,200,000 $ 37,345,000 $ 28,056,000 $ 31,660,000
============ ============ ============ ============
Cost of revenues:
eSecurity Products ...................... $ 7,531,000 $ 7,305,000 $ 16,092,000 $ 7,093,000
Secure Communications Products .......... 15,178,000 12,971,000 11,892,000 11,084,000
Spectria ................................ 2,635,000 2,053,000 1,981,000 2,279,000
------------ ------------ ------------ ------------
Total cost of revenues ........... $ 25,344,000 $ 22,329,000 $ 29,965,000 $ 20,456,000
============ ============ ============ ============
Operating income (loss) ................... $ (1,956,000) $ (2,172,000) $(26,912,000) $ 534,000
Net income (loss) ......................... (2,571,000) (2,255,000) (20,345,000) 1,654,000
Net income (loss) per share:
Basic ................................... $ (.10) $ (.09) $ (.78) $ .06
Diluted ................................. (.10) (.09) (.78) .06

March 31, June 30, September 30, December 31,
2000 2000(4)(5) 2000(5) 2000(5)
------------ ------------ ------------ ------------

Revenues:
eSecurity Products ...................... $ 20,077,000 $ 22,092,000 $ 24,341,000 $ 22,521,000
Secure Communications Products .......... 11,532,000 11,653,000 14,396,000 17,811,000
Spectria ................................ 4,836,000 5,149,000 5,033,000 3,843,000
------------ ------------ ------------ ------------
Total revenues ................... $ 36,445,000 $ 38,894,000 $ 43,770,000 $ 44,175,000
============ ============ ============ ============
Cost of revenues:
eSecurity Products ...................... $ 5,881,000 $ 6,499,000 $ 6,978,000 $ 7,816,000
Secure Communications Products .......... 9,371,000 9,292,000 10,912,000 12,695,000
Spectria ................................ 2,506,000 3,273,000 3,232,000 2,383,000
------------ ------------ ------------ ------------
Total cost of revenues ........... $ 17,758,000 $ 19,064,000 $ 21,122,000 $ 22,894,000
============ ============ ============ ============
Operating income .......................... $ 4,392,000 $ 3,859,000 $ 7,201,000 $ 3,582,000
Net income ................................ 3,131,000 5,028,000 4,646,000 1,641,000
Net income per share:
Basic ................................... $ .13 $ .20 $ .18 $ .06
Diluted ................................. .12 .18 .17 .06

- ----------

(1) Results of operations for the quarter ended March 31, June 30 and September
30, 2001 included pre-tax unrealized losses on marketable trading
securities of $2,589,000, $959,000 and $14,000, respectively, and results
of operations for the quarter ended December 31, 2001 included a pre-tax
unrealized gains on marketable trading securities of $16,000.

F-19

(2) Operating loss and results of operations for the quarter ended September
30, 2001 reflect pre-tax charges for restructuring costs of $6,402,000,
provision for bad debts of $1,612,000, reserve for excess and obsolete
inventory of $7,414,000, write-off of capitalized and developed software of
$2,392,000, warranty reserve of $1,782,000, goodwill impairment of
$4,030,000.

(3) Results of operations for the quarter ended September 30, 2001 reflect
pre-tax investment impairment charge of $1,206,000 and foreign currency
transaction loss of $1,252,000.

(4) Operating income and results of operations for the quarter ended June 30,
2000 reflect a pre-tax asset impairment charge of $2,173,000.

(5) Results of operations for the quarter ended June 30, 2000 and September 30,
2000 included pre-tax unrealized gains on marketable trading securities of
$4,218,000 and $67,000, respectively, and results of operations for the
quarter ended December 31, 2000 included a pre-tax unrealized loss on
marketable trading securities of $1,404,000.

(6) Results of operations for the quarter ended December 31, 2001 includes
other income of approximately $2.5 million resulting from refinement of
estimates made in the third quarter ended September 30, 2001 related to the
non-recurring charges recorded.

Net income (loss) per share is computed independently for each of the
quarters presented and the summation of quarterly amounts may not equal the
total net income (loss) per share reported for the year.

F-20

RAINBOW TECHNOLOGIES, INC.

SCHEDULE II -- CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS
Years Ended December 31, 2001, 2000, and 1999

Balance at Deductions/ Balance at
Beginning Recoveries and End of
Description of Year Additions Write-Offs Year
- ----------- ----------- ----------- ----------- -----------

For the year ended December 31:
2001
Allowance for doubtful accounts receivable ........... $ 1,460,000 $ 2,429,000 $(2,031,000) $ 1,858,000
Excess and obsolete reserve .......................... $ 777,000 $11,905,000 $(6,282,000) $ 6,400,000
2000
Allowance for doubtful accounts receivable ........... $ 579,000 $ 1,078,000 $ (197,000) $ 1,460,000
Excess and obsolete reserve .......................... $ 185,000 $ 1,323,000 $ (731,000) $ 777,000
1999
Allowance for doubtful accounts receivable ........... $ 291,000 $ 434,000 $ (146,000) $ 579,000
Excess and obsolete reserve .......................... $ 202,000 $ 316,000 $ (333,000) $ 185,000

F-21

EXHIBIT INDEX

Exhibit
Number Description
------ -----------

2(i) Agreement and Plan of Reorganization, dated as of January 26,
1995 among the Company, Rainbow Acquisition Inc., a California
corporation and a wholly owned subsidiary of Rainbow, and
Mykotronx, Inc., a California corporation ("Mykotronx")
(incorporated by reference to the Company's Registration
Statement on Form S-4 under the Securities Act of 1933, as
amended, effective on April 20, 1995, Registration No.
33-89918).

2(ii) Agreement and Plan of Merger, dated September 30, 1996, by and
among the Company, RNBO Acquisition Corporation, a Nevada
corporation and a wholly-owned subsidiary of the Company, and
Software Security, Inc., a Connecticut corporation
(incorporated by reference to Exhibit 2(ii) of the Company's
1996 Annual Report on Form 10-K under the Securities Exchange
Act of 1934 filed in March 1997 (the "1996 10-K")).

2(iii) Agreement and Plan of Merger, dated March 6, 1998, by and among
the Company, WRS Acquisition Corp, a California corporation and
wholly owned subsidiary of the Company, and Wyatt River
Software, Inc. (incorporated by reference to Exhibit 2(iii) of
the Company's 1997 Annual Report on Form 10-K under the
Securities Exchange Act of 1934 filed in March 1998 (the "1997
10-K")).

3(i) Articles of Incorporation of Rainbow, as amended (incorporated
by reference to Exhibit 3(a) to Rainbow's Registration
Statement on Form S-18 under the Securities Act of 1933, as
amended, filed on July 20, 1987 -- File No. 33-15956-LA (the
"S-18 Registration Statement")).

3(ii) By-Laws of Rainbow (incorporated by reference to Exhibit 3(b)
to the S-18 Registration Statement).

4(a) See Exhibit 3(i).

4(b) See Exhibit 3(ii).

4(c) Rights Agreement, dated as of July 29, 1997, between the
Company and U.S. Stock Transfer Corporation, as Rights Agent
(incorporated by reference to Exhibit 4(c) to the Company's
1997 10-K).

10(a) Lease for premises at 50 Technology Drive, Irvine, California,
dated June 1, 1995, between the Company and Birtcher Medical
Systems, Inc., a California corporation (filed as an exhibit to
the Company's 1995 Form 10-K).

10(b) Agreement, dated October 1996, between the Company and National
Semiconductor Corporation (incorporated by reference to Exhibit
10(b) of the Company's 1998 Annual Report on Form 10-K under
the Securities Exchange Act of 1934 filed in March, 1999 (the
"1998 10-K")).

10(c) Agreement, dated December 1998, between the Company and EM
Microelectronic-- Marin S.A. (incorporated by reference to
Exhibit 10(c) of the 1998 10-K).

10(d) 1990 Incentive Stock Option Plan as amended (incorporated by
reference to Exhibit 10(j) of the 1991 10-K).

10(e) Employment Agreement, dated February 16, 1990, between the
Company and Walter W. Straub (incorporated by reference to
Exhibit 10(j) of the 1989 10-K).

10(f) Change of Control Agreement, dated February 16, 1990, between
the Company and Walter W. Straub (incorporated by reference to
Exhibit 10(k) of the 1989 10-K).

10(g) Employment Agreement, dated January 15, 1992, between the
Company and Peter M. Craig (incorporated by reference to
Exhibit 10(m) of the 1991 10-K).

10(h) Change of Control Agreement, dated January 15, 1992, between
the Company and Peter M. Craig (incorporated by reference to
Exhibit 10(n) of the 1991 10-K).

10(i) Employment Agreement, dated January 5, 1995, between the
Company and Norman L. Denton, III (incorporated by reference to
Exhibit 10(j) of the Company's 1994 Annual Report on Form 10-K
under the Securities Exchange Act of 1934, filed in March 1995
(the "1994 10-K")).

10(j) Change of Control Agreement, dated January 5, 1995, between the
Company and Norman L. Denton, III (incorporated by reference to
Exhibit 10(k) to the 1994 10-K).

10(k) Employment Agreement, dated January 5, 1995, between the
Company and Patrick E. Fevery (incorporated by reference to
Exhibit 10(l) of the 1994 10-K).

10(l) Change of Control Agreement, dated January 5, 1995, between the
Company and Patrick E. Fevery (incorporated by reference to
Exhibit 10(m) of the 1994 10-K).

F-22

Exhibit
Number Description
------ -----------

10(m) Employment Agreement, dated January 5, 1995, between the
Company and Paul A. Bock (incorporated by reference to Exhibit
10(n) of the 1994 10-K).

10(n) Change of Control Agreement, dated January 5, 1995, between the
Company and Paul A. Bock (incorporated by reference to Exhibit
10(o) of the 1994 10-K).

10(o) Employment Agreement, dated April 7, 1997, between the Company
and Aviram Margalith (incorporated by reference to Exhibit
10(o) of the 1997 10-K).

10(p) Change of Control Agreement, dated April 7, 1997, between the
Company and Aviram Margalith (incorporated by reference to
Exhibit 10(p) of the 1997 10-K).

10(q) Employment Agreement, dated January 1, 1998, between the
Company and Laurie Casey (incorporated by reference to Exhibit
10(q) of the 1997 10-K).

10(r) Change of Control Agreement, dated January 1, 1998, between the
Company and Laurie Casey (incorporated by reference to Exhibit
10(r) of the 1997 10-K).

10(s) Employment Agreement, dated January 1, 1998, between the
Company and Richard Burris (incorporated by reference to
Exhibit 10(s) of the 1997 10-K).

10(t) Change of Control Agreement, dated January 1, 1998, between the
Company and Richard Burris (incorporated by reference to
Exhibit 10(t) of the 1997 10-K).

10(u) Manufacturing Agreement, dated September 30, 1997, between
AlliedSignal, Inc. and Mykotronx, Inc. (incorporated by
reference to Exhibit 10(u) of the 1998 10-K).

10(v) Development Agreement, dated September 30, 1997, between
AlliedSignal, Inc. and Mykotronx, Inc. (incorporated by
reference to Exhibit 10(v) of the 1998 10-K).

10(w) Agreement for Design and Product Purchase, dated September 4,
1997, between IBM Microelectronics and Rainbow Technologies,
Inc. and Mykotronx, Inc. (incorporated by reference to Exhibit
10(w) of the 1998 10-K).

10(x) Leases for premises at 357, 359, and 371 Van Ness Way,
Torrance, California, dated September 8, 1993, September 25,
1996 and October 2, 1997, respectively, between Surf Management
Associates, a California limited partnership, and Mykotronx,
Inc., a California Corporation (incorporated by reference to
Exhibit 10(x) of the 1999 Form 10-K).

10(y) Lease for premises at 111 West Ocean Boulevard, Long Beach,
California, between Stevens Creek Associates, a California
general partnership, and the Company (incorporated by reference
to Exhibit 10(y) of the 1999 Form 10-K).

10(z) Lease for premises at 8 Hughes, Irvine, California, between
Alton Irvine Partners, LLC, a California limited liability
company, and the Company (incorporated by reference to Exhibit
10(z) of the 2000 Form 10-K).

10(aa) 2000 Incentive Stock Option Plan (incorporated by reference to
Rainbow's Registration Statement on Form S-8 filed under the
Securities Act of 1933).

10(bb) Asset Purchase Agreement, dated December 29, 2000 between
Kaster Chase Applied Research Limited and Mykotronx, Inc.
(incorporated by reference to Exhibit 11(b) of the 2000 Form
10-K).

10(cc) 2001 Nonstatutory Stock Option Plan (incorporated by reference
to Rainbow's Registration Statement on Form S-8 filed
under Securities Act of 1933).

21 List of Rainbow's wholly-owned subsidiaries.

23 Consent of Independent Auditors.

(b) Reports of Form 8-K

No reports on Form 8-K have been filed during the three months ended December
31, 2001.

F-23