WAVE SYSTEMS CORP - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K

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

For the fiscal year ended December 31, 2000

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

For the transition period from __________________ to __________________
Commission File Number 0-24752

Wave Systems Corp.
(Exact name of registrant as specified in its charter)

Delaware 13-3477246
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

480 Pleasant Street
Lee, Massachusetts 01238
(Address of principal executive offices) (Zip Code)

413-243-1600
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

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

Class A Common Stock, $.01 par value
(Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES |X| NO [ ]

Indicate by check mark 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. [ ]

The aggregate market value of the shares of Common Stock of the registrant
held by non-affiliates as of February 28, 2001 was $249,627,565 (For purposes of
this calculation, the market value of a share of Class B Common Stock was
assumed to be the same as a share of Class A Common Stock, into which it is
convertible.)

As of, February 28, 2001 there were 49,146,302 shares of the registrant's
Class A Common Stock and 779,211 shares of the registrant's Class B Common Stock
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Proxy Statement for the Annual Stockholders'
Meeting to be held on or about June 26, 2001 are incorporated by reference
into Part III.

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EXCEPT FOR HISTORICAL INFORMATION CONTAINED HEREIN, THIS FORM 10-K CONTAINS
FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE U.S. SECURITIES LITIGATION
REFORM ACT OF 1995. THESE STATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS AND
UNCERTAINTIES THAT MAY CAUSE THE COMPANY'S ACTUAL RESULTS OR OUTCOMES TO BE
MATERIALLY DIFFERENT FROM THOSE ANTICIPATED AND DISCUSSED HEREIN. FURTHER, THE
COMPANY OPERATES IN AN INDUSTRY SECTOR WHERE SECURITIES VALUES MAY BE VOLATILE
AND MAY BE INFLUENCED BY REGULATORY AND OTHER FACTORS BEYOND THE COMPANY'S
CONTROL. IMPORTANT FACTORS THAT THE COMPANY BELIEVES MIGHT CAUSE SUCH
DIFFERENCES ARE DISCUSSED IN THE CAUTIONARY STATEMENTS ACCOMPANYING THE
FORWARD-LOOKING STATEMENTS AND IN THE RISK FACTORS DETAILED IN THE COMPANY'S
OTHER FILINGS WITH THE COMMISSION DURING THE PAST 12 MONTHS. IN ASSESSING
FORWARD-LOOKING STATEMENTS CONTAINED HEREIN, READERS ARE URGED TO READ CAREFULLY
ALL RISK FACTORS AND CAUTIONARY STATEMENTS CONTAINED IN THIS FORM 10-K AND IN
THOSE OTHER FILINGS WITH THE COMMISSION.

Table Of Contents

PART I.........................................................................1
Item 1. Business...........................................................1
Item 2. Properties........................................................11
Item 3. Legal Proceedings.................................................11
Item 4. Submission of Matters to a Vote of Security Holders...............11

PART II.......................................................................12
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters...........................................................12
Item 6. Selected Financial Data...........................................14
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.............................................15
Item 7A. Quantitative and Qualitative Disclosure about Market Risk........19
Item 8. Financial Statements and Supplementary Data.......................19
Item 9. Changes in and Disagreements with Accountant on Accounting and
Financial Disclosure..............................................19

PART III......................................................................20
Item 10. Directors and Executive Officers of the Registrant...............20
Item 11. Executive Compensation...........................................20
Item 12. Security Ownership of Certain Beneficial Owners and Management...20
Item 13. Certain Relationships and Related Transactions...................20

PART IV.......................................................................21
Item 14. Exhibits, Financial Statement Schedules, and Reports on
Form 8-K.........................................................21

EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS.........................................40

PART I

Item 1. BUSINESS

Wave Systems Corp. ("Wave") offers powerful, next-generation solutions for
electronic commerce, making the process easier, versatile, and more secure for
consumers as well as business-to-business applications. We are involved in the
research, development, and market testing of the Wave System, which performs
buying transactions in a range of consumer electronic devices, including
computers, personal digital assistants, and interactive televisions, for use of
electronic content and services. Electronic content and services refer to any
data, graphic, software, video or audio sequence that can be digitally
transmitted or stored, as well as access to services such as broadcast or
telecommunications. Examples include archived newspaper and magazine articles,
on-line books, music selections, clip-art, photographs and video games. Under
our model, electronic content and service providers use the Wave System to allow
consumers to purchase one-time, multiple or permanent use of their content or
service, using a wide range of payment models including rental, pay-for-use, or
outright purchase, much like a phone card or a pay-per-view cable system. We are
also developing a secure e-commerce shopping network, which will offer consumers
access to quality brands and retailers as well as special savings. The Wave
System changes today's centralized e-commerce model by creating a de-centralized
distribution and security system under which consumers will be able to make
individual purchases of images, text, music or video, or make use of software,
or purchase retail goods and services, all executed and recorded in the
consumer's computer or other interactive device. This means that content, goods
and services can be consumed with more efficient and flexible pricing, broader
distribution opportunities, greater protection against unauthorized usage, with
better privacy protection of the consumer's sensitive information.

The Wave System consists of EMBASSY or, EMBedded Application Security
System in consumer devices that provides a core hardware and software foundation
for consumers to purchase electronic content and access goods and services on a
flexible purchase basis. The EMBASSY trusted client platform is a programmable,
low cost "system within a system" that can perform independent transactions such
as metered pay-per-use of electronic content, store sensitive information such
as identities, credit information and account balances and run secure
applications for pay-per-use access to software. The EMBASSY platform is an open
model based on security hardware originally designed for use with "smart cards"
that can be integrated into personal computers and peripherals, interactive
televisions or used as independent components. The WaveMeter application running
in the EMBASSY platform allows e-commerce transactions to occur without the
expense of a real-time network connection for every transaction. This
multi-party trusted client architecture is designed to simultaneously protect
the interests of all parties in an e-commerce transaction.

The EMBASSY securely stores electronic funds and transaction information
about the usage of electronic content to be periodically transmitted securely to
WaveNet, a central transaction processing system. WaveNet manages electronic
codes for scrambling and unscrambling electronic content, processes credit and
usage charges, automatically obtains credit authorization, calculates royalty
distributions and provides user and usage data to electronic content owners. The
Wave System is designed to be compatible with existing content delivery systems,
such as CD-ROMs and the Internet. Using these Wave-enabled distribution systems,
electronic content providers can distribute their products in a secure format
and offer them for sale through the EMBASSY platform, which in turn allows
consumers to purchase and access the electronic content on an as-desired basis.

In order to achieve broad market acceptance of the Wave System, we pursue
strategic relationships with major computer manufacturers, technology suppliers
and systems integrators; and promote the use of the EMBASSY platform to
electronic content owners, particularly developers and distributors of
entertainment, audio, broadcast and educational software. The EMBASSY platform
can manage subscribers and usage of electronic content independent of the type
of content or network on which it is delivered. This means that electronic
content can be delivered on CD-ROM, high-speed wired and wireless broadcasting,
and other forms of transmission.

The Wave System provides a powerful merchandising interface for electronic
content and services at the point of purchase. This is an enticement to
consumers to sample electronic content that they are considering purchasing. The
Wave System provides the consumer with enhanced control of their individual
privacy and secure storage of sensitive information. The Wave System facilitates
the payment of royalties to content providers and service partners while
allowing both customized and broad, inexpensive distribution to customers.

We have enhanced the Wave System to make it acceptable as an open industry
standard for a broad range of security and e-commerce functions in end
user-devices. We have been successful in attracting other companies to port
their applications and services to the Wave System and our EMBASSY platform,
which we believe will increase the value of the system to potential deployment
partners. These strategic relationships have generated what we believe to be
significant joint marketing benefits in our efforts to promote the Wave System
to manufacturers of computers and electronic consumer goods and the electronic
content industry.

Additionally, we have also developed the WaveMeter server, a production
software version of the WaveMeter application that offers some of the features
of the hardware version and has been implemented as part of our Internet
commerce server. The WaveMeter server enables content owners to secure and sell
their intellectual property from a web site. The e-commerce services offered
through the WaveMeter server do not require the consumer or publisher to install
any additional hardware or software.

We were incorporated in Delaware under the name Indata Corp. on August 12,
1988. We changed our name to Cryptologics International, Inc. on December 4,
1989. We changed our name again to Wave Systems Corp. on January 22, 1993. Our
principal executive offices are located at 480 Pleasant Street, Lee,
Massachusetts 01238 and our telephone number is (413) 243-1600.

We are a development stage company and have realized minimal operating
revenues since our inception. For the years ended December 31, 2000, 1999 and
1998 Wave incurred losses to common shareholders of $47,656,000, $28,066,000 and
$17,445,000, respectively. At December 31, 2000 we had an accumulated deficit of
approximately $140,923,000. There can be no assurance that we will ever be
successful in achieving commercial acceptance of the Wave System.

The Wave System

The Wave System is designed to create new revenue streams for owners of
electronic content by improving upon existing distribution systems for
electronic content. Using existing distribution systems such as CD-ROM and the
Internet, electronic content owners distribute their products to customers in
the encrypted Wave-enabled form so it can be offered for sale through the
EMBASSY E-Commerce System. Customers are then able to purchase and access the
electronic content on an as-desired basis. The Wave System allows electronic
content owners to deliver their products to a larger market because the
efficient and secure metering technology facilitates greater flexibility in
content distribution and pricing. Such flexibility makes the Wave System
particularly attractive to developers, distributors and consumers of
entertainment and educational software. Currently, the two primary mechanisms of
delivery of electronic content to the end user are the Internet and CD-ROM. The
Wave System, however, will work with point-to-multi-point data broadcasting via
satellite, broadcast TV, FM radio, floppy disc, DVD and cable modem and similar
high-speed networking.

In addition, the programmable EMBASSY platform is capable of supporting
multiple secure applications from a range of service providers, applications
vendors, and security companies. Our expansion of the EMBASSY platform has
provided a source of increased interest in Wave's technology as a
general-purpose solution for adoption by a wide range of companies in their
platforms and as a mechanism for the secure delivery of electronic content.

The Wave System consists of the EMBASSY E-Commerce System, the WaveMeter
application, a subsystem that records and communicates the usage of electronic
content, and WaveNet, a central transaction processing network. The EMBASSY
platform controls the simultaneous loading and execution of multiple
applications, all on a secure basis. The WaveMeter controls and monitors the
customer's access to encrypted

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electronic information and software. The Wave System is well suited to low-cost
processing of very low priced, rental and rent-to-own electronic content
transactions. With the WaveMeter, application transactions are executed within
the electronic device itself, against a source of funds stored in the WaveMeter
secure memory. The WaveMeter retains this pricing and licensing information,
downloaded from WaveNet, for use in the execution of these transactions.
Transactions are securely stored in the usage log of the WaveMeter for eventual
uploading and reporting to WaveNet. The WaveMeters and WaveNet communicate using
Wave's secure communications protocol.

WaveNet consists of the WaveNet Transaction Processing System ("TXP") and
the WaveNet Information Clearing House ("ICH"). TXP acts as the principal
interface with EMBASSY. Every EMBASSY-equipped device contacts TXP on a periodic
basis. During this secure communication, all stored event information, such as
purchase logs, are uploaded to TXP, additional credit may be requested, pending
events are delivered to the device, and a routine audit check is performed.
There may be a number of TXP systems to distribute access around the globe. TXP
routes all event logs to ICH where they are processed against Wave's royalty
contracts. ICH calculates royalties due to each partner and handles the billing
and reporting services, ensuring that all Wave partners are properly
compensated. WaveNet is presently in operation.

The Wave System is installed into the customer's computer or integrated
into an attached peripheral device. It is based on a semiconductor device that
uses secure certified integrated circuit technology to unscramble data and to
store credit and usage data. At present, the WaveMeter, based on our own silicon
chip, is packaged primarily within a USB device.

We believe that the hardware version of the Wave System with EMBASSY is
the most secure form of content licensing management and metering technology
available today. The EMBASSY hardware and software contain a wide range of
security features. Tampering results in the device automatically locking out
users, and is readily detected. The codes used to unscramble data are loaded at
the time we initialize the EMBASSY device, and are unique and specific to each
device. Every piece of electronic content is protected using a unique code key.
Services are controlled by secure applications running in the EMBASSY platform.
We believe we have designed a security architecture where the value of breaking
into an individual computer system to ascertain the code keys is low, since
there are no common keys that allow the use of such code keys on other systems.

Markets and Business Strategy

Our long-term strategy is to achieve broad market acceptance of the Wave
System as a distributed trust platform for commerce performed in user devices.
To achieve this goal, we pursue strategic relationships with hardware
manufacturers, systems integrators and companies involved in the development of
commerce in electronic content and services. In addition, since the Wave System
is designed to permit greater flexibility in pricing and distribution of
electronic content, it is particularly well-suited for merchandising consumer
content, entertainment and educational software. Therefore, we are targeting
this market segment as a means of rapidly achieving the broad installed base of
the Wave System. We believe that once there is a broad installed base of the
Wave System and EMBASSY, electronic content owners from other market segments
are likely to be attracted to the Wave System. However, we cannot assure you
that the Wave System will achieve any significant market acceptance.

We have focused on forming agreements with strategic partners that will
help us promote the broad-based acceptance of the Wave System as a platform for
commerce in electronic content. We are currently in discussion with original
equipment manufacturers regarding the incorporation of the Wave System and
EMBASSY into their products. We have also focused on pursuing strategic
relationships with companies seeking to distribute electronic content via the
Internet. The compatibility of the Wave System with the Web has provided us with
a product that has already attracted the attention of leaders in the development
of electronic commerce solutions and particularly commerce in electronic
content. We will continue to focus on developing other strategic relationships
to seek to achieve the broad acceptance of the Wave System as a platform for
electronic commerce.

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We have focused on promoting the acceptance of the Wave System by
electronic content owners. The initial target market is entertainment and
educational software developers and distributors. The Wave System has the
capability to provide the home consumer with a new way of acquiring interactive
content and can offer electronic content developers and distributors benefits
similar to those provided by video rental in the film industry. We have invested
heavily in developing relationships with entertainment and educational software
providers. Today, we have over 100 titles functional for demonstration.

Competition

We operate in a highly competitive and fragmented environment that is
characterized by rapidly evolving technology. Many of our competitors and
potential competitors have substantially greater financial and technical
resources. Also, many current and potential competitors have greater name
recognition and more extensive customer bases that could be leveraged, thereby
gaining market share or product acceptance to our detriment. The Wave System
competes with conventional information delivery systems, such as on-line
services like AOL, subscription services on CD-ROM, and services on the
Internet. However, its metering capability is competitive with other electronic
content delivery systems in a number of applications as it is designed to
provide advanced protection against unauthorized usage, accurate and detailed
information on content usage, and transparent operation. Further, it can be
competitive with existing distribution systems, including traditional retail
outlets for entertainment and educational software, due to its ability to offer
these innovative merchandising mechanisms.

We are aware of other metering systems that compete directly with the Wave
System, and other current and evolving technologies that provide some of the
functionality of the Wave System. There are other companies that have developed
or are in the process of developing technologies that are, or in the future may
be, the basis for competitive products in the field of electronic content
distribution and security. Some of those technologies may have an entirely
different approach or means of accomplishing the desired effects of the products
being developed by us. We can provide no assurance that either existing or new
competitors will not develop products that are superior to or that otherwise
achieve greater market acceptance than our products.

The Wave System is subject to competition from producers of hardware-based
controllers such as hardware-based key systems and software unlocking systems.
We compete with well-established producers of hardware-based unlocking systems
such as Rainbow Technologies, Inc. We also compete with developers of software
unlocking systems such as Portland Software. We also provide basic security
services that compete with companies such as QPass and PrivaSeek in providing
electronic wallets and certain e-commerce capabilities. The Wave System differs
from existing hardware-based and software unlocking systems in several ways.
While these systems primarily operate as "on/off switches" to control the use of
electronic content and services, they are limited in their ability to measure
and record usage information. The Wave System is designed to offer protection of
content from unauthorized usage, measure and record usage information, calculate
royalties due to content publishers and handle billing and reporting functions.
The system operates at low cost (because it does not require constant
communication with and authorization from a centralized processor); is fast,
convenient and essentially transparent to the end user. Both hardware
controllers and software unlocking systems offer only part of the functionality
of the Wave System. Our products are also designed to provide an advanced
solution for the broadcasting and multicasting of data.

Many large information industry players are forming alliances and
attempting to capitalize on the information delivery options offered by the
Internet. In electronic content delivery via the Internet, the Wave System
competes with electronic commerce payment technologies developed and offered by
IBM Micropayment Service, Broadvision, Connect, CyberCash, and Open Market.
However, many of the electronic commerce payment technologies may be used as
acceptable currency through the Wave System and may be complementary to, rather
than competitive with, the Wave System.

The Wave System has been designed to be compatible with currently
available and developing distribution media in order to make it attractive to
both distributors and consumers of electronic content. A consumer with an
installed EMBASSY platform may be able to purchase Wave-enabled electronic
content from sources on CD-ROM and/or the Internet, as well as from sources
distributing electronic content via other developing media. In addition, with
the incorporation of the rental and rent-to-own functionality, the Wave

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System can offer greater merchandising flexibility than is possible using
currently available electronic commerce solutions. We caution you, however, that
the Wave System may never achieve the broad-based acceptance necessary to make
it a viable competitor with existing and developing electronic commerce
solutions.

International Market

Our technologies are controlled under various United States export control
laws and regulations and will require export licenses for certain exports
outside of the United States and Canada. We have received full export license
from the U.S. Department of Commerce for the sale and export of our single-key
Data Encryption Standard (DES) products. We have also received an export license
for our triple-key DES products under the provisions of a License Exception KMI,
granted by the Bureau of Export Administration of the U.S. Department of
Commerce. We can provide no assurance that we will have patent protection or
that it will not infringe patents of other parties in foreign jurisdictions.
Because electronic monitoring and the transmission of audited usage and
financial information on end users or payment instructions may be subject to
varying statutory or regulatory controls in foreign jurisdictions, the use of
all portions of the Wave System may not be permitted in any particular foreign
jurisdiction.

Wave Systems formed a strategic alliance in 1998 with HP VerSecure in the
development of the underlying architecture of the EMBASSY platform. HP VerSecure
is designed to provide a security management framework for EMBASSY that controls
security functions in the device. The primary function of the VerSecure system
is to provide a management system that enables the EMBASSY hardware to have
strong security features that can be selectively enabled or disabled in order to
comply with the regulations of various countries. This capability is intended to
allow computer manufacturers to build a single, consistent product, which can be
shipped worldwide, regardless of local restrictions.

Proprietary Rights and Licenses and Intellectual Property

Our success depends, in part, on our ability to enjoy or obtain protection
for our products and technologies under United States and foreign patent laws,
copyright laws and other intellectual property laws, to preserve our trade
secrets and to operate without infringing the proprietary rights of third
parties. Any issued patent owned or licensed by us may not, however, afford
adequate protection to us and may be challenged, invalidated, infringed upon or
circumvented. Furthermore, you should understand that our activities may
infringe upon patents owned by others.

In addition, we may be required to obtain licenses to patents or other
proprietary rights of other parties. Licenses required under any such patents or
proprietary rights may not be made available on terms acceptable to us, if at
all. If we are required to and do not obtain such licenses, we would be
prevented from, or encounter delays in the development and marketing of, our
products and technologies while we attempted to design around such patents or
other rights. Such attempts may not be successful. Failure to obtain such
licenses or to design around such patents or other rights would have a material
adverse effect on us.

We hold non-exclusive patent rights relating to the metered use of
encrypted data in local memory under a limited license from Titan Corporation to
a patent jointly held by Titan and a third party (the "Licensed Patent"). This
license agreement restricts us from metering information produced and used
solely by a government entity or producing products that meter this information.
In addition, this license agreement is subject to the rights of the joint owners
of this patent, who have the right to exploit, or to license this patent to
third parties in a manner that may be competitive with us. The joint owners of
this patent may compete with us or license this patent to a competitor of ours,
or our business may exceed the scope of this license agreement. Pursuant to this
license agreement, we are obligated to pay certain royalties to Titan. Pursuant
to this license agreement, we have granted to Titan the exclusive right to use
our patents for products distributed to government entities. On February 28,
1997 we and Titan executed an addendum to this license agreement whereby we
received a sole license to this patent to develop and distribute products to the
in-home consumer microcomputer market segment. Under this addendum to this
license agreement, Titan waived any and all defaults by us under this license
agreement occurring prior to February 28, 1997.

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We are aware of four United States patents (the "Third Party Patents")
each having some claims that are similar to some of the claims in the Licensed
Patent. Based upon information currently known to us, some of the claims of both
the Licensed Patent and the Third Party Patents cover certain material aspects
of our technology. Therefore, the commercialization of our technology would be
subject to the rights of the holder of the Third Party Patents unless we are
able to invalidate such claims or license such technology. Also, the holder of
the Third Party Patents or a licensee of the Third Party Patents could seek to
invalidate such claims of the Licensed Patent and therefore be able to
commercialize a technology similar to our technology. In either case, in order
to invalidate the other party's patent rights, the party claiming invalidity
might need to prove that it invented the claimed subject matter prior to the
other party. We cannot provide any assurance that we would be successful in
invalidating such claims of the Third Party Patents or that the holder of the
Third Party Patents or a licensee of the Third Party Patents would not be
successful in invalidating the claims of the Licensed Patent. Furthermore, we
cannot provide any assurance that the Third Party Patents could be proven to be
invalid on any other basis. Any proceeding involving the validity of the
Licensed Patent and the Third Party Patents would be protracted and costly. In
any suit contesting the validity of a patent, the patent being contested would
be entitled to a presumption of validity and the contesting party would be
required to demonstrate invalidity of such patent by clear and convincing
evidence.

If the Third Party Patents are not invalid insofar as their claims relate
to our technology, then we would require a license from the holder of the Third
Party Patents to commercialize our technology and make, use, or sell products or
practice methods, or license others to sell products or use methods, utilizing
this technology in the United States. Due to the uncertainty as to whether the
Third Party Patents could be proved to be invalid, we engaged in negotiations
with the holder of the Third Party Patents to obtain a license under the Third
Party Patents. As a result of these negotiations, Wave has entered into a
license of limited rights to use the Third Party Patents in connection with
certain uses. Wave did not obtain, however, a general license to use such
patents in connection with activities not connected with the licensor.

We have been issued eight United States patents relating to encryption and
to our proprietary Embassy and WaveCommerce technology. We also have four
patents pending before the United States Patent Office. In addition, we have
filed foreign patent applications for six patents. Our patents are material to
protecting some of our technology.

Some of our patent rights derive from a license from Wave's Chairman ,Mr.
Peter J. Sprague, of his rights in these patents, and several agreements with
former officers regarding their rights in these patents. The license agreement
with Mr. Sprague requires us to make royalty payments to him and Dr. John R.
Michener, a former officer, in a total amount equal to two percent of gross
revenues less certain adjustments. This royalty payment is apportioned 75
percent to Mr. Sprague and 25 percent to Dr. Michener. The payment of royalties
is secured by a security interest in and to our patents. We believe that these
agreements as a whole provide us with exclusive rights under our patents. We
cannot assure you, however, that we will enjoy exclusive rights to these patents
under such agreements.

On January 26, 1996, we received notice from E-Data Corporation (formerly
Interactive Gift Express, Inc.), claiming that the practice of our technology
infringes U.S. and foreign patents owned by E-Data Corporation, and offering to
license such patents to us. We are currently obtaining information needed to
investigate the merits of this claim. We believe that there is a viable argument
for non-infringement. The patents owned by E-Data Corporation are currently
being litigated by third parties. We are not involved in these proceedings, nor
are we aware of the current status of any litigation with respect to these
patents.

We rely on trade secrets and proprietary know-how, which we protect, in
part, by confidentiality agreements with our employees and contract partners.
However, we caution you that our confidentiality agreements may be breached and
we may not have adequate remedies is such a breach occurs. Furthermore, we can
provide no assurance that our trade secrets will not otherwise become known or
be independently discovered by competitors.

We also rely on copyright to prevent the unauthorized duplication of our
software and hardware products. We have and will continue to protect our
software and our copyright interest therein through

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agreements with our consultants. We can provide no assurance that copyright laws
will adequately protect our technology.

We have registered trademark and service mark registrations with the
United States Patent and Trademark Office for the marks WaveMeter and WaveNet,
EMBASSY, Great Stuff Network, Second Shift (the Wave juggler logo),
WaveCommerce, Wave Interactive Network, WaveDirect, WINPublish,
WINPurchase,CablePC, iShopHere and Face/Eye logo (iShopHere.com face logo). We
have submitted trademark registrations for, EMBASSY System, Netpass, CharityWave
and Trust @ the Edge. Wave intends to apply for additional name and logo marks
in the United States and foreign jurisdictions as appropriate. No assurance can
be given that federal registration of any of these trademarks in the United
States will be granted. We have abandoned our prior applications for DataWave,
InfoWave, and WaveTrac.

Research and Development

The Wave System incorporates semiconductor, encryption/decryption,
software transaction processing and other technologies in which we have made a
substantial investment in research and development. We will likely be required
to continue to make substantial investments in the design of the Wave System,
including EMBASSY and the WaveCommerce services. For the years ended December
31, 2000, 1999, and 1998 we expended approximately $20.9 million, $10.7 million
and $6.2 million, respectively, on research and development activities (such
amounts include the value of stock issued). In addition to our ongoing research
and development activities, in July 1997 we licensed technology and in-process
research and development from Aladdin Knowledge Systems for cash and warrants
valued at $3.9 million. The success of the Wave System depends to a large extent
on our ability to adapt the Wave System for use with various methods for the
distribution of electronic content, the ability of the Wave technology to
interface with various platform environments, and the ability of the Wave System
to work in many application environments. Incorporation of Aladdin's Hasp
technology furthered these efforts and illustrates the adaptive capabilities of
the Wave System. A significant portion of our future research and development
expenditures will be used to adapt the Wave System accordingly.

We will also continue to expend a significant amount of resources on the
development of new iterations of the EMBASSY and the WaveCommerce applications.
By providing various means of linking the EMBASSY to the customer's computer or
network, we will be more likely to achieve broad acceptance of the Wave System.
We are currently developing other forms of EMBASSY to target other market needs.

We are now focusing increased resources on developing our operational
infrastructure. We are placing greater emphasis on developing internal
production and fulfillment systems and marketing infrastructure to distribute
the Wave System. We will also increase the resources available to WaveNet to
adapt to changing market requirements. We plan to continue to expand WaveNet to
handle more end users, to implement more sophisticated pricing methodologies and
to add greater financial system flexibility.

Recent Developments

In April 1999, we joined with Sarnoff Corporation to announce the
formation of a new joint venture, WaveXpress. WaveXpress aims to provide secure
data broadcast architecture, infrastructure and content services to broadcasters
and content providers. WaveXpress is developing technology and services that
will allow content providers to send electronic content to properly equipped
PC's by utilizing unused bandwidth in the Digital Television (DTV) spectrum.
Consumers will be able to purchase this electronic content directly through a
secure network connection, thus enabling a significant new revenue stream for
broadcasters. On October 15, 1999 Wave and Sarnoff signed a joint venture
agreement which formally established WaveXpress. Under this agreement Sarnoff
and affiliates received a 40% equity stake in WaveXpress. Wave, and its
affiliates who purchased founders stock in April 1999, for a nominal amount, own
the remaining 60% of the outstanding capital stock. The affiliates of Wave
include Peter Sprague and Steven Sprague, the Chief Executive Officer and
President of Wave, respectively, certain members of the Board of Directors of
Wave and certain employees of Wave. This affiliate group owns, in the aggregate,
7% of the outstanding capital stock of WaveXpress. In addition, Wave is
currently funding WaveXpress through a series of convertible notes. These notes
can be converted into equity at a predetermined conversion rate. Through

-7-

December 31, 2000, Wave has loaned WaveXpress approximately $16.8 million.
Neither Sarnoff nor any of the other minority shareholders are obligated to
provide any funding to the venture. For the years ended December 31, 2000 and
1999, the financial statements of WaveXpress have been consolidated with Wave's
financial statements.

We also announced, in April 1999, the first fee-free internet commerce
service for digital content distribution ("MyPublish"). MyPublish will allow
individuals and small businesses to harness the Internet to publish, promote,
and sell various types of electronic content, such as newsletters,
subscriptions, images, audio, video, and software. MyPublish is a complete,
simple-to-use community commerce solution that can be easily integrated into any
Web service.

On July 27, 1999, we completed the acquisition of N*ABLE Technologies,
Inc. ("N*ABLE"), a security solutions company that produces hardware-based
security solutions for the protection of sensitive user data within network
client systems, including a hardware-based security co-processor that manages
the secure transfer of payment or sensitive personal information to and from
desktop computers. We paid the shareholders of N*ABLE the aggregate
consideration of 2,280,821 shares of Class A Common Stock (subject to certain
post-closing adjustments through April 2000) for their shares. The closing price
per share as of the closing date was $10.38. Founded in 1996, N*ABLE was located
in Danvers, Massachusetts, with offices in Cupertino, California and Bouguenais,
France. The transaction was accounted for under the pooling-of-interests method
of accounting.

In September 1999, we entered into an agreement with Cyber-COMM, a banking
consortium led by France's largest banks, to license our EMBASSY technology for
the development of a European network of enhanced smart card readers, to be used
for conducting various types of e-commerce.

In November 1999, we launched CharityWave, a free online charitable
contribution service that guarantees participating non-profit organizations 100
percent of all monies donated. Through CharityWave, visitors to the Web sites of
participating charities can make instant secure donations electronically, at any
hour. CharityWave is initially providing this service to thirty prominent
charities, including United Way International, National Wildlife Federation,
National Conference for Community and Justice, National Center for Missing and
Exploited Children, and World Monuments Fund.

In February 2000 we announced the demonstration of an EMBASSY V1.0 chip
enabled Compaq smart card keyboard. Designed specifically to meet stringent
European banking standards, this smart-card reader was developed by Compaq for
Cyber-COMM(R), a consortium led by French banks whose mandate is to find
technology solutions to solve online consumer security, trust and privacy
issues. Cyber-COMM has licensed Wave's EMBASSY technology for the development of
a European network of enhanced smart-card readers for conducting e-commerce.

On March 7, 2000, we secured $122 million through the private placement of
approximately 3.6 million shares of Class A Common Stock at $34.00 per share to
institutional and accredited investors. Pacific Growth Equities, Inc. ("Pacific
Growth") acted as sole placement agent for the private placement. Proceeds, net
of expenses, including the commission paid to Pacific Growth, were approximately
$114.9 million.

Also in March 2000, we announced a comprehensive relationship to license
and integrate InterTrust's digital rights management (DRM) technology into
Wave's digital broadcast network infrastructure and EMBASSY Trusted Client
hardware platform and services. This will allow content providers to protect and
manage the distribution of music, published documents, videos, and other digital
goods with flexible new delivery and business models.

On March 27 2000, Advanced Micro Devices (AMD) and Wave announced an
alliance to integrate new security functions for commercial and consumer
computing by working jointly to incorporate Wave's Trusted Client architecture
as a core component of PC motherboards and other platforms. The two companies
began to work together to provide extended functionality based on an evolving
standard for PC platform security being created by the Trusted Computing
Platform Alliance (TCPA). Both AMD and Wave participate in the TCPA, which is an
industry alliance focused on hardware and software specifications to

-8-

enhance security and trust of the PC platform. New security functionality
announced by the AMD/Wave alliance included new user privacy options,
distributed e-commerce and transaction capability, and a programmable security
hardware infrastructure. The two companies announced that after successfully
integrating the security functions, AMD will include this new functionality into
some commercial and consumer motherboard reference designs - AMD's "blueprint"
for PC motherboards given to PC manufacturers. These AMD reference designs will
include specifications on how and where Trusted Client technology can be
integrated into PC motherboards in an effort to standardize and deploy Trusted
Client technology as an open systems specification

On April 18, 2000, Cyber-COMM certified EMBASSY as the preferred method of
implementation of Cyber-COMM's specifications for Level 5 secure smart card
readers. Cyber-COMM further announced it will promote EMBASSY as its preferred
technical solution to third party hardware vendors wishing to develop Cyber-COMM
secure devices for deployment in France and elsewhere.

On June 27, 2000, we announced the expansion of our Global Wave Limited
("Global Wave") European Joint Venture with Redwave plc ("Redwave"). The new
agreement increased Wave's equity in the venture, affirmed both parties'
commitments to the business, and was supported by increased funding to speed
deployment of the EMBASSY(TM) technology in European markets. Under the terms
of the new agreement, Wave's share of the joint venture vehicle, known as
GlobalWave Limited, increased from 25% to 40%.

In July 2000, The New York Times Neediest Cases Fund and Wave announced an
agreement which would facilitate online contributions from the public to The New
York Times Neediest Cases Fund and The New York Times College Scholarship
Program using CharityWave.com, a Wave Systems Web site. CharityWave.com will
provide the Internet infrastructure to enable secure online donations to both
funds at no cost, and credit card fees will be absorbed by Wave Systems Corp.
CharityWave.com allows donations up to $500, all of which will be transferred to
the funds.

In August 2000, we announced Trust @ the Edge, a strategic new security
architectural model for the Internet that creates multi-party trust in user
devices. Trust @ the Edge specifies the integration of strong security in every
user device, a major breakthrough in the challenge of creating trusted and
private digital relationships while enabling reliable electronic exchange and
commerce over the Internet. With support from a growing range of strategic
industry partners in the semiconductor, PC, content, security and software
industries the goal is to drive the adoption of the user based trust model for
security in every user device.

Also in August 2000, we announced the availability of Wave's EMBASSY
Applet Developers Kit (ADK) paving the way for third party developers to
independently create applications for unique Trust @ the Edge applications. For
the first time the open and programmable functionality of EMBASSY, including
resources such as non-volatile storage, unique ID's, flexible I/O, a real-time
clock and cryptography accelerators became available to third party developers
for enhancing the security of existing applications, as well as introducing a
range of new services that are dependent on a Trusted Client.

On August 22, 2000, National Semiconductor announced plans to develop a
complete security co-processor for PCs that supported the Trusted Computing
Platform Alliance ("TCPA") security specification that would include
cryptographic technology licensed from Wave. The two companies had recently
signed a full development agreement.

Also on August 22, 2000, Compaq and Wave jointly announced that the two
companies are working together to develop Trusted Client solutions for the PC
industry. The two companies demonstrated a secure smart card keyboard that
supports the evolving TCPA industry security specifications. The use of a
keyboard as the TCPA-defined Trusted Platform Module (TPM) also demonstrates the
viability of a separable trust module, enabling enhanced security and trust to
be delivered to existing machines as well as new systems.

On September 6, 2000, we announced the completion of the acquisition of
substantially all of the assets of Nashville, TN-based Indigo Networks, LLC and
its e-commerce shopping network, iShopHere.com, for 374,889 shares of Wave's
Class A Common Stock. The aggregate purchase price totaled $7,445,000,

-9-

based on the average closing price of Wave's Class A Common Stock for the ten
trading days immediately preceding the date of the acquisition of $19.30 per
share. By combining iShopHere.com's access to leading merchants with Wave's
EMBASSY Trusted Client e-commerce technology, a new secure service offering can
be made available that allows consumers to complete transactions over the
Internet with advanced security, reliability and trust. Wave intends to leverage
iShopHere.com as a key offering to affinity groups who form digital
relationships using Wave's Trusted Client technologies. These could include
charitable, volunteer, and fraternal groups, trade unions, schools or other
associations. It is anticipated that once aggregated and securely linked through
Wave's Trusted Client Technologies, these affinity groups could be extremely
attractive to merchants seeking access to targeted customers. The revenue model
for Wave is generally to receive a percentage of sales generated from an
iShopHere link, or a cost per click fee for internet traffic to the merchants'
sites from iShopHere.com.

In October 2000, we announced the signing of a $10 million
comprehensive development agreement with BIZ Interactive Zone ("BIZ") to
integrate Wave's EMBASSY Trusted Client technology into the BIZ Secure
Service Provider(TM) Suite to be deployed in 5 million digital set top boxes
and integrated gateway products such as cable and DSL modems. The agreement
also calls for Wave to develop two applets that will be deployed in each BIZ
SSP(TM) device shipped under the agreement. Under the terms of the agreement,
Wave Systems will receive $10 million for technology and application
development, and pre-paid royalties and fees for deployment of 5 million
EMBASSY devices under the SSP brand and for deployment of 10 million secure
services applets that will run on the SSP(TM)/EMBASSY co-branded devices. In
a previous announcement in September the two companies formed a strategic
partnership which included licensing and utilization of the full range of
Wave's leading EMBASSY Trusted Client technologies, as well as Wave's
services including the EMBASSY Trust Assurance Network, distributed
transaction systems, and content protection applications using digital rights
management.

On November 13, 2000, we announced jointly with Advanced Micro Devices
(AMD) the demonstration of the first Wave/AMD Trusted Client PC solution. The
AMD and Wave reference platform is designed to be compliant with the TCPA
specifications. AMD and Wave's solution adds significant additional
functionality including user privacy options, distributed e-commerce and
transaction capability. The open, programmable security hardware infrastructure
has been designed to provide PC OEMS a template for building cost optimized
Trusted Client PCs.

Also on November 13, 2000, we announced that Wave has agreed to deliver
key enabling technologies and services in support of a ten year agreement
announced by BIZ Interactive Zone and Electronic Data Systems (EDS) earlier in
the day. The BIZ SSP solution suite of 15 primary products and services will be
one of the core offerings of EDS' worldwide Information Assurance Group. Core
technologies and services announced by EDS/BIZ that Wave has agreed to provide,
as part of the strategic relationship referred to above, include the SSP EMBASSY
Trusted Client, The SSP Applet Development Kit, SSP Smart Card Readers, SSP
Metering, SSP Agent Addressed (XNS), and the SSP Broadcasting Kit.

In December, the Canadian Imperial Bank of Commerce World Markets ("CIBC")
and Wave announced an agreement to automate the production of CIBC World Markets
USA Miracle Day, a children's charity event for the holiday season. On, December
6, CIBC World Markets institutional sales and trading staff, as well as account
executives in the Private Client Division, joined their colleagues around the
world in donating fees and commissions to children's charities. Wave used its
CharityWave.com infrastructure to provide the following services: the automation
of charity nominations using the Internet, charity applications, an electronic
database, due diligence and screening of charity applicants, online processing
of employee contributions and raffle, real-time customer relations management
and administration of charity payments.

On February 2, 2001, Wave entered into a stock purchase agreement (the
"Agreement") with BIZ Interactive Zone, Inc. ("BIZ") to acquire 3,600,000
shares of the Series B Preferred Stock of BIZ in exchange for 2,000,000
shares of Wave's Class A Common Stock. Wave's investment in BIZ represents
approximately 17.8% of the outstanding capital stock of BIZ. Accordingly,
Wave intends to account for this investment using the Cost Method of
accounting, as the investment represents less than a 20% ownership interest.
BIZ is a privately held company.

In a related event, Litronic, Inc., ("Litronic"), a provider of
authentication and encryption security technology signed a term sheet to
merge with BIZ. Litronic trades on the NASDAQ National Stock Market. The
transaction is to be structured as a reverse triangular merger whereby
Litronic Stockholders will own approximately 47% and BIZ stockholders will
own 53% of the combined company.

As part of the Agreement, in the event of a merger with Litronic, Wave
shall own 13.78% of the outstanding shares, on a fully diluted basis, of the
combined company resulting from the proposed merger.

Employees

As of December 31, 2000, we employed 217 full-time employees, 110 of whom
were involved in sales, marketing and administration and 107 of whom were
involved in research and development (Including 36 employed by WaveXpress, 18 of
whom were in sales, marketing and administration and 18 of whom were involved in
research and development.) As of December 31, 2000 we retained the services of
40 full-time consultants, 3 of whom were retained by WaveXpress. We believe our
employee relations are satisfactory.

-10-

Item 2. Properties

Summarized below is a listing of properties leased by Wave. Our principal
research and development activities are conducted at the Princeton and Cupertino
facilities.

Monthly Base Utility /Common
Facility Sq. Ft. Rent Costs Lease Expires
- --------------- --------- ----------------- ------------------ --------------
Lee, MA 16,548 $ 12,189 - 0 - Jul. 2002
Danvers, MA 3,510 4,826 350 Sep. 2002
New York, NY 4,500 12,000 - 0 - May 2001
Nashville, TN 5,757 3,310 451 Oct. 2002
Princeton, NJ 21,673 43,346 2,312 Dec. 2002
Cupertino, CA 12,329 38,741 1,240 Oct. 2002
New York, NY 12,282 42,987 2,272 Apr. 2010
San Jose, CA 2,728 6,138 - 0 - Dec. 2001

Item 3. Legal Proceedings

As of December 31, 2000 Wave was not involved in any material litigation,
nor, to management's knowledge is any material litigation threatened against
them or their properties other than routine litigation arising in the ordinary
course of business.

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

On June 26, 2000, the Company held its Annual Meeting of shareholders. At
the Annual Meeting, the shareholders voted on the following matters:

1. The election of seven directors to hold office until the next Annual
Meeting and until their successors are duly elected and qualified. The previous
board was re-elected with the following results:

DIRECTOR FOR AGAINST
- ---------------------- ------------- -----------
Peter J. Sprague 45,191,791 165,145
John E. Bagalay, Jr. 45,191,691 165,245
Philippe Bertin 45,191,791 165,145
George Gilder 45,191,791 165,145
John E. McConnaughy, Jr. 45,191,691 165,245
Steven Sprague 45,191,791 165,145
Nolan Bushnell 45,191,791 165,145

2. An amendment to the Company's 1994 Employee Stock Option Plan (the
"Plan") to increase the number of shares of the Company's Class A Common Stock
reserved for issuance under the Plan from 8,000,000 to 13,000,000. The proposal
was adopted with the following results: 10,179,279 affirmative votes, 1,780,814
negative votes; 209,301 votes withheld; and 33,186,542 broker non-votes.

-11-

PART II

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

The Class A common stock trades on the Nasdaq National Market under the
symbol "WAVX". The following table sets forth, for the periods indicated, the
high and low closing sales prices per share for the Class A common stock. There
is no established trading market for our Class B common stock.

High Low
---- ---
Year Ended December 31, 1999
First Quarter $27.50 $3.72
Second Quarter 26.19 13.375
Third Quarter 20.00 8.00
Fourth Quarter 16.88 9.00

Year Ending December 31, 2000
First Quarter $47.94 $11.50
Second Quarter 32.44 13.00
Third Quarter 24.06 15.06
Fourth Quarter 16.00 4.50

As of February 28, 2001, there were approximately 38,000 holders of our
Class A common stock. As of such date, there were 30 holders of our Class B
common stock.

On February 28, 2001, the last sale price reported on the Nasdaq National
Market for the Class A common stock was $5.00.

We have never declared nor paid any cash dividends on our capital stock.
We currently anticipate that we will retain all future earnings, if any, to fund
the development and growth of our business and do not anticipate paying any cash
dividends on our capital stock in the foreseeable future.

Recent Sales of Unregistered Securities

On August 31, 2000 Wave exchanged 374,889 shares of its Class A Common
Stock, at a price of $19.30 per share for substantially all of the assets of
Indigo Networks, LLC and its e-commerce shopping network, iShopHere.com.
Additional costs to complete the transaction were $210,000. These Securities
were registered on September 21, 2000.

On March 7, 2000 Wave sold 3,600,800 shares of its Class A Common Stock,
at a price of $34.00 per share, for an aggregate purchase price of $122,427,200.
The shares were sold to a group of accredited investors pursuant to Regulation D
promulgated under the Securities Act of 1933, as amended. Pacific Growth
Equities, Inc. acted as sole placement agent for the private placement,
receiving a commission of approximately $7.3 million, for their services. These
shares were registered on March 24, 2000

In January, 2000, Wave issued 275,000 shares of its class A Common Stock
to one (1) accredited investor, for an aggregate purchase price of $1,100,000.
These shares were issued upon the exercise of a warrant granted on January 26,
1999. The warrant to purchase 275,000 shares of the Company's Class A Common
Stock at an exercise price of $4.00 per share, was exercisable until January 26,
2004. The warrant was issued as consideration for a $2,000,000 promissory note,
bearing no interest, due January 26, 2002.

-12-

On December 15, 1999 Wave sold 69,626 shares of its Class A Common Stock,
at a price of $14.36 in exchange for a license of the Hewlett-Packard Company's
VerSecure software technology. These securities were registered on December 23,
1999.

On November 5, 1999, Internet Technology Group, Plc ("ITG") exercised the
remainder of a warrant for 800,000 shares of Class A Common Stock. This was in
conjunction with Wave who exercised a warrant in ITG for 1,000,000 shares.
During the year ITG had previously exercised the initial portion of a warrant
for 200,000 shares of Class A Common Stock.

On March 30, 1999 Wave issued 181,818 shares of its Class A Common Stock,
at a price of $11.00 per share, in satisfaction of the then outstanding
principal amount of $2,000,000 on a note it had issued to Carriage Partners,
LLC, pursuant to a conversion provision of the note.

On March 23, 1999 Wave sold 2,090,954 shares of it Class A Common Stock,
at a price of $11.00 per share, for an aggregate purchase price of $23,000,494.
The shares were sold to a group of accredited investors pursuant to Regulation D
promulgated under the Act. Pacific Growth Equities, Inc. acted as sole placement
agent for the private placement.

On March 31, 1999 Aladdin Knowledge Systems Ltd. ("Aladdin") exercised a
portion of their warrant for 1,216,136 Class A Common Stock. During June of
1998, Aladdin also exercised a portion of the second warrant to purchase
1,000,000 shares of common stock.

On March 6, 1998 Wave issued 150,000 shares of newly created Series G
Convertible Preferred Stock, par value $.01 ("Series G Convertible Preferred
Stock") at a price of $20 per share, for an aggregate purchase price of
$3,000,000. The shares were sold to one (1) accredited investor pursuant to
Regulation D promulgated under the Act. The Series G Convertible Preferred Stock
is convertible into Class A Common Stock, par value $.01 ("Class A Common
Stock") at an effective conversion price of the lower of (a) $1.12 and (b) 80%
of the average of the five (5) lowest trading prices of the Class A Common Stock
during (x) any day on which the Class A Common Stock is traded on The Nasdaq
National Market or The Nasdaq SmallCap Market or principal national securities
exchange or market on which the Class A Common Stock has been listed, or (y) if
the Class A Common Stock is not listed on The Nasdaq National Market or The
Nasdaq SmallCap Market or any stock exchange or market, any day on which the
Class A Common Stock is traded in the over-the-counter market, as reported by
the OTC Bulletin Board, or (z) if the Class A Common Stock is not quoted on the
OTC Bulletin Board, any day on which the Class A Common Stock is quoted in the
over-the-counter market as reported by the National Quotation Bureau
Incorporated (or any similar organization or agency succeeding its functions of
reporting prices) ("Trading Days"), as reported by Bloomberg Information
Services, Inc. during the ten (10) Trading Days immediately preceding the
Conversion Date, as defined in the Certificate of Designation of the Series G
Convertible Preferred Stock. In addition to the Series G Convertible Preferred
Stock, the Company also issued warrants to purchase a total of 225,000 shares of
Class A Common Stock at an exercise price of $1.38 per share, exercisable until
October 9, 2002. As of February 18, 1999, all of the shares of the Series G
Convertible Preferred Stock have been converted into Class A Common Stock.

-13-

Item 6. Selected Financial Data

Statement of Operations Data

Year ended December 31
----------------------------------------------------------------------------
2000 1999 1998 1997 1996
------------ ------------ ------------ ------------ ------------

Revenues, Net ....................... $ 332,522 $ 187,515 $ 47,681 $ 23,659 $ 3,220
Cost of Sales .................... 58,864 93,170 37,488 12,947 1,762
------------ ------------ ------------ ------------ ------------
Gross Margin ..................... 273,658 94,345 10,193 10,712 1,458
------------ ------------ ------------ ------------ ------------
Operating expenses:
Selling, general and
administrative ................ 26,553,634 16,749,276 11,945,273 9,557,198 6,553,003
Acquisition Costs ................ -- 1,494,000 -- -- --
Amortization of Goodwill ......... 573,544 -- -- 769,886 --
Aladdin Technology License
Expense ....................... -- -- 3,889,000 -- --
In- Process Research &
Development ................... 2,176,000 -- -- -- --
Research and development ......... 20,866,055 10,697,971 6,247,105 4,715,334 3,751,871
------------ ------------ ------------ ------------ ------------
50,169,233 28,941,247 18,192,378 18,931,418 10,304,874
------------ ------------ ------------ ------------ ------------
Other income (expense):
ITG Technology License Fee ....... -- 1,250,000 2,750,000 1,000,000 --
License ITG Warrant Cost ......... -- (1,100,000) -- -- --
Equity in net losses of
Globalwave .................... (3,406,491) -- -- -- --
Net interest and other income
(expense) ........................ 5,646,173 (455,669) (53,842) (91,929) 176,870
------------ ------------ ------------ ------------ ------------
Net loss ............................ (47,655,893) (28,052,572) (16,586,027) (18,012,635) (10,126,546)
Accrued dividends on preferred
stock ............................ -- 13,239 108,863 809,982 199,614
Assured incremental yield ........... -- -- 750,000 1,673,000 670,965
------------ ------------ ------------ ------------ ------------
Net loss to
common stockholders .............. $(47,655,893) $(28,065,811) $(17,444,890) $(20,495,617) $(10,997,125)
============ ============ ============ ============ ============
Weighted average number of common
shares outstanding during the
period ........................... 46,149,587 38,365,573 31,580,665 23,224,569 17,237,405
Loss per common share-basic and
diluted .......................... $ (1.03) $ (.73) $ (.55) $ (.88) $ (.64)
============ ============ ============ ============ ============
Cash dividends declared per
common share ..................... -0- -0- -0- -0- -0-

-14-

Balance Sheet Data

As of December 31
---------------------------------------------------------------------
2000 1999 1998 1997 1996
----------- ----------- ----------- ----------- -----------

Working capital
(deficiency) .............. $76,099,347 $ 4,870,443 $ (770,959) $ 4,772,873 $ 3,197,519

Total assets ................. 98,084,061 16,531,883 6,023,991 7,965,827 6,237,219

Long-term liabilities ........ -- -- -- 522,124 465,500

Total Liabilities ............ 7,870,009 6,823,643 5,289,634 1,949,886 1,402,663

Redeemable preferred
stock ...................... -- -- 493,201 471,601 3,275,596
----------- ----------- ----------- ----------- -----------
Total stockholders' equity
(deficiency) .............. $90,214,452 $ 9,708,240 $ (241,156) $(5,151,700) $ 1,558,960
=========== =========== =========== =========== ===========

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

Overview

Wave is creating a new electronic commerce model for digital information
and services based on client-side security, transactions and trust. Since our
inception in February of 1988, we have devoted substantially all of our efforts
and resources to research, feasibility studies, design, development, and market
testing of a distributed trust system that enables client based transactions,
including the metered usage of electronic content and services (the "Wave
System"). Electronic content and services refers to any data, graphic software,
video or audio sequence that can be digitally transmitted and/or stored. As our
research and development activities matured, we were able to devote increased
resources to the creation of content distribution services, market development
and the application of the Wave System to end-user services. From inception
through December 31, 2000, we have realized only minimal operating revenues, and
do not anticipate significant revenues in the near future. There are numerous
risks that could adversely affect our efforts to achieve profitability.

In June 2000, the Company increased its ownership percentage of Global
Wave Limited ("Global Wave"), from 25% to 40% through its wholly owned holding
company Earthquest Limited ("Earthquest"). On October 10, 2000, Wave and
Earthquest entered into an agreement with Global Wave and its Joint Venture
partner Redwave, Plc. (formerly ITG) to subscribe for additional shares to
maintain a 40% ownership interest in the venture. As consideration for the
additional shares, Wave committed to invest approximately $5.7 million in cash
and development services. Wave accounts for its investment in Globalwave using
the equity method of accounting, and accordingly recognizes its share (40%) of
Globalwave's results of operations in the accompanying consolidated statement of
operations.

On July 27, 1999, Wave completed the acquisition of N*ABLE Technologies,
Inc., ("N*ABLE") a security solutions company that produces hardware-based
security solutions for the protection of sensitive user data within network
client systems, including a hardware-based security co-processor that manages
the secure transfer of payment or sensitive personal information to and from
desktop computers. Wave paid the shareholders of N*ABLE total consideration of
2,280,821 shares of our Class A common stock (subject to certain post closing
adjustments). The closing price per share as of the closing date was $10.38.
Founded in 1996, N*ABLE was located in Danvers, Massachusetts, with offices in
Cupertino, California and Bouguenais, France. The transaction was accounted for
under the pooling-of-interests method of accounting and the

-15-

financial data in the Selected Financial Data table above and in the discussion
below has been restated for all periods assuming the acquisition occurred on the
first day of the first period presented.

In April 1999, WaveXpress, a joint venture between Wave and Sarnoff
Corporation was established. For technology licensed to WaveXpress, Sarnoff and
affiliates received a 40% equity stake in WaveXpress. Wave and its affiliates
who purchased, for a nominal amount, founders stock in April 1999 own the
remaining 60% of the outstanding capital stock. The affiliates of Wave include
Peter Sprague and Steven Sprague, the Chief Executive Officer and President of
Wave, respectively, certain members of the Board of Directors of Wave and
certain employees of Wave. This affiliate group owns, in the aggregate, 7% of
the outstanding capital stock of WaveXpress. Wave is also funding WaveXpress
through a series of convertible notes and expects to continue to provide funding
until an external round of funding can be attained. These notes can be converted
into equity by the Company. Through December 31, 2000, Wave has loaned
approximately $16.8 million in funds under these notes.

The financial statements of WaveXpress have been consolidated with those
of Wave for the years ended December 31, 2000 and 1999. As the joint venture
minority partners, Sarnoff Corporation and the Wave affiliates, have not
contributed any cash and are not required to fund the operations of the joint
venture, Wave has not recorded a minority interest in WaveXpress in the
consolidated financial statements and therefore, has reflected 100% of
WaveXpress' operating results in these consolidated financial statements.

The following discussion related to the consolidated financial statements
of Wave should be read in conjunction with the financial statements appearing in
Item 8.

Results of operations

Comparison of the years ended December 31, 2000 and 1999

For the twelve months ended December 31, 2000 and December 31, 1999,
revenues were $332,522 and $187,515 respectively. Revenue growth can be
attributed to increased software and technology licensing agreements in 2000 as
opposed to hardware security co-processor and associated software products from
which most of the 1999 revenues were derived. The cost of sales for the twelve
months ended December 31, 2000, was $58,864 compared with $93,170 for the same
period in 1999. This was the result of higher margins on sales associated with
licensing arrangements versus sales of hardware products.

Research and development expenses for the twelve months ended December 31,
2000 were $20,866,055, as compared to $10,697,971 for the comparable period of
1999. This 95% increase in research and development expenses was primarily
attributable to an increase in headcount and consultant costs associated with
the design and development of our proprietary integrated circuit technology and
software. Significant development initiatives undertaken during the year ended
December 31, 2000 included major enhancements to Wavenet, the development of
EMBASSY II, the development of the EMBASSY applet developers kit, the creation
of the "Trust Assurance Network" and the development of core EMBASSY applets. In
addition, WaveXpress experienced significant expenditures in developing its data
broadcast system. WaveXpress' research and development expenses were $5,188,098
for the year ended December 31, 2000 versus $769,733 in for the year ended
December 31, 1999, since its operations only began in October of 1999.

Selling, general and administrative expenses for the twelve months ended
December 31, 2000 were $26,553,634 as compared to $16,749,276 for the comparable
period of 1999. The 58.5% increase in selling, general and administrative
expenses was primarily attributable to an increase in personnel, consultants and
professional fees, trade shows, equipment and other related costs associated
with the development and marketing of new applications and pursuing new markets
for our technology. In addition, WaveXpress was in operation for the entire year
ended December 31, 2000, as its operations began in October of 1999. WaveXpress
incurred selling, general and administrative expenses of $4,992,285 in 2000,
compared to $1,084,415 for 1999.

In addition to the increases in research and development and selling,
general and administrative expenses referred to above, Wave recognized an
in-process R&D expense of $2,176,000 and goodwill amortization of $573,544 in
the year ended December 31, 2000 associated with the acquisition of
iShopHere.com. These expenses were not incurred for the year-ended December 31,
1999. Acquisition costs

-16-

associated with pooling-of-interest acquisitions were $0 for the year-ended
December 31, 2000, versus $1,494,000 for the year-ended December 31, 1999. For
the reasons described above, total operating expenses for the year-ended
December 31, 2000 were $50,169,234 compared with $28,941,247 for the year-ended
December 31, 1999.

While, the overall growth rate in operating expenses accelerated for the
year ended December 31, 2000 to 73% from 59% in the prior corresponding period,
the growth rate in operating expenses is expected to decrease significantly for
the year ending December 31, 2001, as Wave has reached the stage in its
development where significant increases in expenditures will not be required for
it to reach its goals in terms of technology, product development, marketing
initiatives and deployment.

Net interest and other income/(expense) for the twelve months ended
December 31, 2000 was $5,646,173 as compared to ($455,669) for the comparable
period of 1999. This change resulted from increased interest income of
$4,486,410, primarily attributable to an increase in interest-bearing assets.
This was a direct result of the private placement of Class A Common Stock for an
aggregate purchase price of $122,427,000; a gain of approximately $542,000 on
the sale of marketable equity securities; and the elimination of $833,000 of
interest expense resulting from the pay-off of all outstanding debt. In
addition, Wave incurred other charges of $240,000 in 1999. No such charges were
incurred in 2000.

Equity in the net losses of Global Wave, an unconsolidated subsidiary
accounted for under the equity method, was $3,406,491 for the year-ended
December 31,2000. No losses associated with this subsidiary were recognized in
1999 or any prior years, as Wave had not funded nor had it committed to provide
any funding prior to 2000.

Wave did not realize any license fee income for the year ended December
31, 2000 versus the $1,250,000 that was recognized for the year ended December
31, 1999. The license fee for 1999 was the final portion of a $5 million fee
paid by Internet Technology Group, Plc ("ITG") to Wave as part of a joint
venture agreement under which ITG received the right to market the Wave
technology in European and Middle Eastern markets. Additional development work
has been committed, to support increased distribution efforts in 2001 at a cost
of approximately $1.6 million.

For the year ended December 31, 2000, WaveXpress incurred a net loss of
approximately $11.2 million versus approximately $1.9 million for the year ended
December 31, 1999. WaveXpress has not realized any revenues since inception. The
expense components that make up their net losses for the years-ended December 31
2000 and 1999 are described above.

Due to the reasons set forth above, the net loss for the twelve months
ended December 31, 2000 was $47,655,894 as compared to $28,052,572 for the
comparable period of 1999. The net loss for the twelve months ended December 31,
2000 to common stockholders was $47,655,894 as compared to $28,065,811 for the
comparable period of 1999.

Comparison of the years ended December 31, 1999 and 1998

For the twelve months ended December 31, 1999 and December 31, 1998,
revenues were $187,515 and $47,681, respectively. Revenue growth was attributed
to the increased sales of hardware security co-processor and associated software
products. The cost of sales for the twelve months ended December 31, 1999, was
$93,170 compared with $37,488 in 1998. This is a result of higher sales
associated with hardware products.

Research and development expenses for the twelve months ended December 31,
1999 were $10,697,971, as compared to $6,247,105 for the comparable period of
1998. This 71% increase in research and development expenses was primarily
attributable to an increase in headcount and consultant costs associated with
the design and development of our proprietary integrated circuit technology and
software. Wave continued to aggressively staff and fund additional development
initiatives, including WaveXpress, MyPublish and CharityWave.

Selling, general and administrative expenses for the twelve months ended
December 31, 1999 were $16,749,276, as compared to $11,945,273 for the
comparable period of 1998. The 40% increase in selling, general and
administrative expenses was primarily attributable to an increase in personnel,
consultants

-17-

and professional fees, trade shows, equipment and other related costs associated
with the development and marketing of new applications and new markets for our
technology. Acquisition costs related to the N*Able acquisition amounted to
$1,494,000.Interest income for the twelve months ended December 31, 1999 was
$617,306, as compared to $231,820 for the comparable period of 1998. The
increase in interest income was primarily attributable to an increase in
interest-bearing assets, which were a direct result of the private placement of
Class A Common Stock for an aggregate purchase price of $23,000,494.

Interest expense for the twelve months ended December 31, 1999 was
$832,976, as compared to interest expense of $285,662 for the comparable period
of 1998. This increase in interest expense is primarily attributable to a
non-cash expense of approximately $666,000 for the value of warrants to acquire
275,000 shares of Class A Common Stock issued as part of the bridge loan
financing, and a non-cash interest charge of approximately $151,000 on a note to
Southeast Interactive Technologies Fund I. On October 18, 1998, we amended the
Southeast Interactive Technologies note so that it was convertible at any time
from April 1, 1999 to April 18, 1999, reducing the conversion price to $0.95 per
share. Additional warrants for 75,000 shares were issued as part of this
amendment, and the fair value of these warrants was $106,000. Additionally, the
fair value of the reduced conversion price was $274,000. We amortized such
amounts as additional interest expense from the date that the note was amended
and the warrant issued through the earliest conversion date of April 1, 1999.

License fee income for the year ended December 31, 1999 was $1,250,000, as
compared with $2,750,000 for 1998. The license fees for both 1999 and 1998 were
portions of a $5 million fee paid by ITG to Wave as part of a joint venture
agreement under which ITG receives the right to market the Wave technology in
European and Middle Eastern markets. Additional development work is expected to
support increased distribution efforts.

On June 9, 1999 the company and PC Free Inc., ("PC Free") a worldwide
customer-based computer system provider signed an agreement to embed the
company's EMBASSY E-commerce system in PC Free's computer systems. Part of the
agreement required Wave to advance PC Free $240,000. As consideration for the
advance, Wave was to receive from PC Free warrants to purchase the stock of PC
Free. Wave subsequently determined that the initial investment had no value and
it was written off during December 1999.

For the period April 1999, date of inception, to December 31, 1999,
WaveXpress' operating results were a net loss of approximately $1.9 million and
license fees paid of approximately $1.8 million. The $1.8 million license fee
has been capitalized and is included in other assets on the consolidated balance
sheet at December 31, 1999.

Due to the reasons set forth above, our net loss for the twelve months
ended December 31, 1999 was $28,052,572 as compared to $16,586,027 for the
comparable period of 1998. The net loss for the twelve months ended December 31,
1999 to common stockholders was $28,065,811, as compared to $17,444,890 for the
comparable period of 1998.

Acquired In-Process Research and Development

During the year ended December 31, 2000, Wave recorded in-process
research and development ("IPRD") charges of $2,176,000 related to the
acquisition of Indigo Networks, LLC ("Indigo") and its e-commerce shopping
network, iShopHere.com. The portion of the purchase price allocated to
in-process research and development for this acquisition was approximately
29% of the total purchase price of $7,445,000. Wave's management was
primarily responsible for estimating the fair value of purchased in-process
research and development. At the acquisition date, Indigo was in the process
of developing technology which would add functionality and features, and
developing a new platform for its product. The IPRD had not yet reached
technological feasibility, had no alternative uses, and may not have achieved
commercial viability. At the acquisition date, management estimated that
completion of the IPRD would be accomplished in November, 2000. The initial
development effort had commenced in January, 2000. At the valuation date, the
new technology had not reached a completed prototype stage, although some
beta testing on portions of the technology had begun. At the valuation date,
the IPRD was approximately 75% complete, based on costs incurred on the IPRD
through the acquisition date versus the total costs estimated to complete the
project. The IPRD was substantially completed with the time originally
estimated. The IPRD projected was valued using an income approach. This
approach took into consideration earnings remaining after deducting from cash
flows related to the in-process technology, the market rates of return on
contributory assets, including assembled workforce, merchant agreements
working capital and fixed assets. The cash flows were then discounted to
present value at an appropriate rate. The discount rate was determined by an
analysis of the risks associated with each of the identified intangible
assets. The resulting net cash flows to which the discount rate of 27% was
applied were based on management's estimates of revenues, operating expenses
and income taxes from such acquired in-process technology.

Liquidity and capital resources

We have experienced net losses and negative cash flow from operations
since our inception, and, as of December 31, 2000, had a deficit accumulated
during the development stage of $140,923,067, and stockholders' equity of
$90,214,452. We have financed our operations principally through the issuance of
Class A and B Common Stock and various series of preferred stock, for total
proceeds since inception of approximately $229,214,000

At December 31, 2000, we had $80,703,890 in cash and cash equivalents. At
December 31, 1999, we had $6,290,045 in cash and cash equivalents. We held
$1,923,305 in marketable securities at December 31, 2000 due to the ITG Warrant
exercise. Marketable securities at December 31, 1999 were $4,480,500. The
increase in cash and cash equivalents was primarily attributable to cash
proceeds from a private placement of 3,600,800 shares of our Class A Common
Stock, for net proceeds of $114,977,416. We also received proceeds of $2,162,457
as a cash distribution upon the acquisition of ITG, of which we owned 1,000,000
shares. Warrants were exercised during the year for proceeds of $1,334,245, and
employee incentive stock options were exercised for total proceeds of
$4,971,182.

-18-

Cash used during the period consisted of $39,234,315 to fund operations,
$5,599,300 to acquire property, plant, equipment and intangible assets; and
$4,142,000 was invested in Global Wave. Wave has a further commitment to invest
an additional $1.6 million (approximately) in Global Wave by the end of 2001.
While Wave does not have any firm commitments to purchase additional property
and equipment, we fully expect to incur expenditures necessary to attain our
deployment goals in 2001.

WaveXpress, our majority-owned subsidiary and joint development venture
with Sarnoff Corporation and other affiliates, has been funded entirely by Wave
through a series of convertible promissory notes (the "Notes"). Through December
31, 2000. Wave has provided approximately $16.8 million in funds under these
notes. Wave expects to continue funding WaveXpress through these and similar
notes until it can secure a round of external funding, which is expected to
occur during 2001. Presently, Wave has committed to funding WaveXpress up to an
additional $4.7 million under the notes.

As of December 31, 2000, we had available net operating loss carryforwards
for Federal income tax purposes of approximately $104.9 million. Because of the
"change in ownership" provisions of the Tax Reform Act of 1986, our net
operating loss carryforwards may be subject to an annual limitation on the
utilization of these carryforwards against taxable income in future periods if a
cumulative change in ownership of more than 50 percent of Wave occurs within any
three-year period. We have made no determination concerning whether there has
been such a cumulative change in ownership. However, we believe that it is
likely that such a change in ownership occurred prior to or following the
completion of our initial public offering in September 1994.

At December 31, 2000, we had working capital of $76,099,347. We expect we
may incur substantial additional expenses resulting in significant losses at
least through the period ending December 31, 2001, due to minimal revenues and
increased sales and marketing expenses associated with initial market entry, and
continued research and development costs.

We anticipate that our existing capital resources will be adequate to
satisfy our capital requirements through the end of 2001.

Item 7A. Quantitative and Qualitative Disclosure about Market Risk

The exposure to market risk associated with interest rate-sensitive
instruments is not material. Wave's investment portfolio consists primarily of
money market funds that meet high credit quality standards and the amount of
credit exposure to any one issue is limited. In addition, we hold a minority
equity investment in a publicly traded company, the value if which is subject to
market price volatility.

Item 8. Financial Statements and Supplementary Data

The consolidated financial statements, the notes thereto, and the
independent auditors' report thereon are presented beginning at page F-1 of this
Form 10-K and are hereby incorporated by reference into this Item 8.

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

Not Applicable.

-19-

PART III

Item 10. Directors and Executive Officers of the Registrant

The response to this item is incorporated by reference from the discussion
responsive thereto under the captions "Management" and "Section 16(a) Beneficial
Ownership Reporting Compliance" in Wave's Proxy Statement for the 2001 Annual
Meeting of Stockholders.

Item 11. Executive Compensation

The response to this item is incorporated by reference from the discussion
responsive thereto under the caption "Executive Compensation" in Wave's Proxy
Statement for the 2001 Annual Meeting of Stockholders.

Item 12. Security Ownership of Certain Beneficial Owners and Management

The response to this item is incorporated by reference from the discussion
responsive thereto under the caption "Security Ownership of Certain Beneficial
Owners and Management" in Wave's Proxy Statement for the 2001 Annual Meeting of
Stockholders.

Item 13. Certain Relationships and Related Transactions

The response to this item is incorporated by reference from the discussion
responsive thereto under the captions "Certain Relationships and Related
Transactions" in Wave's Proxy Statement for the 2001 Annual Meeting of
Stockholders.

-20-

PART IV

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

(a) (1) Financial Statements:

Page(s)
-------

Index to Consolidated Financial Statements F F-1

Independent Auditors' Report F-2

Consolidated Balance Sheets as of December 31, 2000 and 1999 F-3

Consolidated Statements of Operations for each of the years
ended December 31, 2000, 1999 and 1998 and
for the period from February 12, 1988 (inception) through December 31, 2000 F-4

Consolidated Statements of Stockholders' Equity (Deficiency) and Other Comprehensive
Income for each of the years ended December 31, 2000, 1999 and 1998 and for the period
from February 12, 1988 (inception) through December 31, 2000 F-5

Consolidated Statements of Cash Flows for each of the years ended December 31, 2000, 1999
and 1998 and for the period from February 12, 1988 (inception) through December 31, 2000 F-10

Notes to Consolidated Financial Statements F-12

(a) (2) Financial Statement Schedules:

All schedules have been omitted since they are either not required or
not applicable.

(a) (3) Exhibits:

Exhibit No. Description of Exhibit
--------------- -----------------------------------------------------
3.1 -- Restated Certificate of Incorporation of
Registrant (incorporated by reference to Exhibit 3.1
of the Registrant's Registration Statement on Form
S-1, File No. 33-75286)

3.2 -- Bylaws of Registrant (incorporated by reference to
Exhibit 3.2 of the Registrant's Registration
Statement on Form S-1, File No. 33-75286)

4.1 -- Form of Stock Certificate of Class A Common Stock
(incorporated by reference to Exhibit 4.1 of the
Registrant's Registration Statement on Form S-1, File
No. 33-75286)

4.2 -- Form of Representative's Warrant Agreement,
including the form of Representative's Warrant
(incorporated by reference to Exhibit 4.2 of the
Registrant's Registration Statement on Form S-1, File
No. 33-75286)

4.3 -- Certificate of Designation of Series B Preferred
Stock of Wave Systems Corp. as filed with the
Delaware Secretary of State on May 24, 1996
(incorporated by reference to Exhibit 3.1 of the
Registrant's Current Report on Form 8-K filed on May
30, 1996, File No. 0-24752)

4.4 -- Certificate of Designation of Series C Convertible
Preferred Stock of Wave Systems Corp. as filed with
the Delaware Secretary of State on December 27, 1996
(incorporated by reference to Exhibit 3.1 of the
Registrant's Current Report on Form 8-K filed on
January 8, 1997, File No. 0-24752)

4.5 -- Certificate of Designation of Series D Convertible
Preferred Stock of Wave Systems Corp. as filed with
the Delaware Secretary of State on December 27, 1996
(incorporated by reference to Exhibit 3.1 of the
Registrant's Current Report on Form 8-K filed on June
3, 1997, File No. 0-24752)

-21-

Exhibit No. Description of Exhibit
--------------- -----------------------------------------------------
4.6 -- Certificate of Designation of Series F Convertible
Preferred Stock of Wave Systems Corp. as filed with
the Delaware Secretary of State on October 9, 1997
(incorporated by reference to Exhibit 3.1 of the
Registrant's Current Report on Form 8-K filed on
October 15, 1997, File No. 0-24752)

4.7 -- Certificate of Designation of Series G Convertible
Preferred Stock of Wave Systems Corp. as filed with
the Delaware Secretary of State on March 5,--1998
(incorporated by reference to Exhibit 3.1 of the
Registrant's Current Report on Form 8-K filed on
March 19, 1998, File No. 0-24752)

+10.1 -- Joint Technology Development Agreement, dated as
of May 1, 1992, between The Titan Corporation and
Cryptologics International, Inc. (incorporated by
reference to Exhibit 10.2 of the Registrant's
Registration Statement on Form S-1, File No.
33-75286)

+10.2 -- License and Cross-License Agreement, dated as of
May 1, 1992, between The Titan Corporation and
Cryptologics International, Inc. (incorporated by
reference to Exhibit 10.3 of the Registrant's
Registration Statement on Form S-1, File No.
33-75286)

10.3 -- Amendment to License and Cross-License Agreement,
dated as of August 27, 1993, between The Titan
Corporation and Wave Systems Corp. (incorporated by
reference to Exhibit 10.4 of the Registrant's
Registration Statement on Form S-1, File No.
33-75286)

10.4 -- Amended and Restated License Agreement, dated
February 14, 1994, by and among Wave Systems Corp.,
Peter J. Sprague and John R. Michener (incorporated
by reference to Exhibit 10.5 of the Registrant's
Registration Statement on Form S-1, File No.
33-75286)

+10.5 -- Wave Systems Corp. 1994 Stock Option Plan
(incorporated by reference to Exhibit 10.6 of the
Registrant's Registration Statement on Form S-1, File
No. 33-75286)

+10.6 -- Wave Systems Corp. Non-Employee Directors Stock
Option Plan (incorporated by reference to Exhibit
10.7 of the Registrant's Registration Statement on
Form S-1, File No. 33-75286)

-22-

Exhibit No. Description of Exhibit
--------------- -----------------------------------------------------

10.7 -- Addendum to License and Cross-License Agreement,
dated February 28, 1997, between The Titan
Corporation and Wave Systems Corp. (incorporated by
reference to Exhibit 10.10 of the Registrant's
Current Report on Form 10-K filed on March 24, 1997,
file No. 0-24752)

10.8 -- Convertible Promissory Note, dated January 26,
1999, between Carriage Partners, LLC and Wave Systems
Corp.

+10.9 -- Employment Contract, dated June 8, 1998, between
Gerard T. Feeney and Wave Systems Corp.

+10.10 -- Employment Contract, dated November 10, 1998,
between Steven Sprague and Wave Systems Corp.

10.11 -- Agreement and Plan of Merger, dated as of July 27,
1999, by and among Wave, Wave Acquisition
Corporation (a Delaware corporation and wholly-
owned subsidiary of Wave) and N*Able Technologies,
Incorporated (incorporated by reference to
Exhibit 99.1 of the Registrant's current report on
Form 8-K filed on August 12, 1999. (File No.
0-24752)

10.12 -- Asset Purchase Agreement dated August 13, 2000,
by and among Wave Systems Corp. and Indigo
Networks, L.L.C. (incorporated by reference to
Exhibit 99.1 of the Registrant's current report on
Form 8-K, filed on September 15, 2000 (File No.
0-24752)

10.13 -- Agreement to subscribe for 40,000 shares of Global
Wave, Ltd, dated October 10, 2000, by and among
Wave Systems Corp., Redwave, plc, Global Wave,
Ltd., and Earthquest, Ltd. (a United Kingdom
Company and wholly-owned subsidiary of Wave)

23.1 -- Consent of Independent Auditors - KPMG LLP

- -------------
+ Confidential treatment has been granted as to portions of this exhibit.
++ Management contract or compensatory plan.

(b) Reports on Form 8-k

There have been no reports on Form 8-K filed during the quarter-ended
December 31, 2000.

-23-

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.

Dated: March 21, 2001
WAVE SYSTEMS CORP.

By: /s/ Peter J. Sprague
--------------------
Name: Peter J. Sprague
Title: Chairman

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

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

/s/ Peter J. Sprague
- --------------------------------
Peter J. Sprague Chairman March 21, 2001

/s/ Steven Sprague
- --------------------------------
Steven Sprague President, Chief Executive Officer and March 21, 2001
Director

/s/ John E. Bagalay, Jr.
- --------------------------------
John E. Bagalay, Jr. Director March 21, 2001

/s/ Michael Seedman
- --------------------------------
Michael Seedman Director March 21, 2001

/s/ George Gilder
- --------------------------------
George Gilder Director March 21, 2001

/s/ John E. McConnaughy, Jr.
- --------------------------------
John E. McConnaughy, Jr. Director March 21, 2001

/s/ Nolan Bushnell
- --------------------------------
Nolan Bushnell Director March 21, 2001

/s/ Gerard T. Feeney
- --------------------------------
Gerard T. Feeney Senior Vice President, Finance March 21, 2001
and Administration, Chief Financial
Officer and Secretary (Principal
Financial Officer and Duly Authorized
Officer of the Registrant

-24-

F-1

Index to Consolidated Financial Statements

Page(s)
-------
Independent Auditors' Report F-2

Consolidated Balance Sheets as of December 31, 2000 and 1999 F-3

Consolidated Statements of Operations for each of the years ended
December 31, 2000, 1999 and 1998 and for the period from February 12,
1988 (inception) through December 31, 2000 F-4

Consolidated Statements of Stockholders' Equity (Deficiency) and
Other Comprehensive Income for each of the years ended
December 31, 2000, 1999 and 1998 and for the period from
February 12, 1988 (inception) through December 31, 2000 F-5

Consolidated Statements of Cash Flows for each of the years ended
December 31, 2000, 1999 and 1998 and for the period from
February 12, 1988 (inception) through December 31, 2000 F-10

Notes to Consolidated Financial Statements F-12

F-2

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Wave Systems Corp.:

We have audited the consolidated financial statements of Wave Systems Corp. and
subsidiaries (a development stage corporation) as listed in the accompanying
index. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. 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 consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Wave Systems Corp.
and subsidiaries as of December 31, 2000 and 1999, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2000 and for the period from February 12, 1988 (date of
inception) to December 31, 2000 in conformity with accounting principles
generally accepted in the United States of America.

KPMG LLP

Boston, Massachusetts
February 23, 2001

F-3

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Consolidated Balance Sheets
December 31, 2000 and 1999

2000 1999
------------- -------------

Assets
Current assets:
Cash and cash equivalents $ 80,703,890 $ 6,290,045
Marketable securities 1,923,305 4,480,500
Inventories 625,148 431,686
Prepaid expenses and other receivables 717,013 491,855
------------- -------------

Total current assets 83,969,356 11,694,086

Investment in Global Wave 735,509 --
Property and equipment, net 5,201,869 2,680,874
Intangible assets, net 2,895,000 1,750,000
Goodwill and acquisition intangibles, net of accumulated amortization of $573,544 4,005,202 --
Other assets 1,277,525 406,923
------------- -------------

Total Assets 98,084,461 16,531,883
============= =============

Liabilities and Stockholders' equity

Current liabilities:
Accounts payable and accrued expenses 7,870,009 6,823,643

Total current liabilities 7,870,009 6,823,643
------------- -------------

Common stock, $.01 par value. Authorized 75,000,000 shares as Class A; issued
and outstanding 47,051,197 in 2000 and 39,445,683 in 1999 470,512 394,457
Common stock, $.01 par value. Authorized 13,000,000 shares as Class B; issued
and outstanding 779,211 in 2000 and 2,050,507 in 1999 7,792 20,505
Capital in excess of par value 228,735,910 99,854,111
Deficit accumulated during the development stage (140,923,066) (93,267,173)

Other Comprehensive Income - unrealized gain on marketable securities 1,923,304 2,860,500
Less: Note receivable from stockholder, including accrued interest of $105,985
in 1999 -- (154,160)
------------- -------------

Total stockholders' equity 90,214,452 9,708,240
------------- -------------

Commitments and contingencies

Total Liabilities and Stockholders Equity $ 98,084,461 $ 16,531,883
============= =============

See accompanying notes to consolidated financial statements.

F-4

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Consolidated Statements of Operations

Years ended December 31, 2000, 1999, 1998 and period
from February 12, 1988 (date of inception)
through December 31, 2000

Period from
February 12, 1988
(date of inception)
through December 31,
2000 1999 1998 2000
------------- ------------- ------------- --------------------

Revenues, net ..................................... $ 332,522 $ 187,515 $ 47,681 $ 594,597
Cost of sales .................................. 58,864 93,170 37,488 204,231
------------- ------------- ------------- -------------
Gross margin ...................................... 273,658 94,345 10,193 390,366
------------- ------------- ------------- -------------
Operating expenses:
Selling, general and administrative ............ 26,553,634 16,749,276 11,945,273 84,287,596
Research and development ....................... 20,866,055 10,697,971 6,247,105 54,261,925
Acquisition Costs .............................. -- 1,494,000 -- 1,494,000
Write-off of goodwill .......................... -- -- -- 769,886
Amortization of Goodwill ....................... 573,544 -- -- 573,544
Aladdin license expense ........................ -- -- -- 3,889,000
In Process research and
development expense ......................... 2,176,000 -- -- 2,176,000
------------- ------------- ------------- -------------
50,169,233 28,941,247 18,192,378 147,451,951
------------- ------------- ------------- -------------
Other income (expense):
Interest income ................................ 5,103,716 617,306 231,820 7,025,294
Interest expense ............................... -- (832,976) (285,662) (1,695,461)
Equity in net losses of Global Wave ............ (3,406,491) -- -- (3,406,491)
Gain on sale of marketable securities .......... 542,457 -- -- 542,457
License fee .................................... -- 1,250,000 2,750,000 5,000,000
License warrant cost ........................... -- -- (1,100,000) (1,100,000)
Other (expense) ................................ -- (240,000) -- (227,280)
------------- ------------- ------------- -------------
2,239,682 794,330 1,596,158 6,138,519
------------- ------------- ------------- -------------
Net loss .......................................... (47,655,893) (28,052,572) (16,586,027) (140,923,066)

Accrued dividends on preferred stock (including
accretion of assured incremental yield on
preferred stock of $750,000 in 1998) ........... -- 13,239 858,863 4,350,597
------------- ------------- ------------- -------------
Net loss to common stockholders ................... $ (47,655,893) $ (28,065,811) $ (17,444,890) $(145,273,663)
============= ============= ============= =============
Loss per common share - basic and diluted ......... $ (1.03) $ (.73) $ (.55) $ (8.85)
============= ============= ============= =============
Weighted average number of common shares
outstanding during the period .................. 46,149,587 38,365,573 31,580,665 16,409,582
============= ============= ============= =============

See accompanying notes to consolidated financial statements.

F-5

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income

Class A Class B Capital
common stock common stock in excess of
Shares Amount Shares Amount par value
------------ ------------ ------------ ------------ ------------

Shares issued to founders at $.003 per share -- $ -- 4,680,000 $ 46,800 $ (31,200)
Shares issued at $1.25 per share, net of expenses of
$36,574 from September through November 1988 -- -- 300,000 3,000 335,426
Net loss for period ended December 31, 1988 -- -- -- -- --
------------ ------------ ------------ ------------ ------------

Balance at December 31, 1988 -- -- 4,980,000 49,800 304,226
Shares issued at $1.25 per share, net of expenses of
$68,750, from January through December 1989 -- -- 270,000 2,700 266,050
Shares issued at $1.25 per share in July 1989 as
compensation for services rendered -- -- 1,920 19 2,381

Shares issued by principal stockholders at $1.25
per share in December 1989 as compensation
for services rendered -- -- -- -- 374,000
Net loss for year ended December 31, 1989 -- -- -- -- --
------------ ------------ ------------ ------------ ------------

Balance at December 31, 1989 -- -- 5,251,920 52,519 946,657

Shares issued by principal stockholder at $1.25
per share in March 1990 as compensation for
services rendered -- -- -- -- 56,250
Shares issued by principal stockholder at $.50 per
share in March 1990 as compensation for
services rendered -- -- -- -- 60,000
Shares issued at $1.67 per share in May 1990 as
compensation for services rendered -- -- 6,000 60 9,940
Shares issued at $1.67 per share, net of expenses of
$5,000 in March, April, November and December 1990 -- -- 390,000 3,900 641,100
Net loss for year ended December 31, 1990 -- -- -- -- --
------------ ------------ ------------ ------------ ------------

Balance at December 31, 1990 -- -- 5,647,920 56,479 1,713,947

Shares issued at $1.67 per share from March
through November 1991 -- -- 315,000 3,150 521,850
Shares issued at $1.67 per share in November
1991 as compensation for services rendered -- -- 19,800 198 32,802
Net loss for year ended December 31, 1991 -- -- -- -- --
------------ ------------ ------------ ------------ ------------

Balance at December 31, 1991 (carried forward) -- -- 5,982,720 59,827 2,268,599

Deficit
accumulated Note
during the receivable
development Deferred from
stage compensation stockholder Total
------------ ------------ ------------ ------------

Shares issued to founders at $.003 per share $ -- $ -- $ -- $ 15,600
Shares issued at $1.25 per share, net of expenses of
$36,574 from September through November 1988 -- -- -- 338,426
Net loss for period ended December 31, 1988 (326,832) -- -- (326,832)
------------ ------------ ------------ ------------

Balance at December 31, 1988 (326,832) -- -- 27,194

Shares issued at $1.25 per share, net of expenses of
$68,750, from January through December 1989 -- -- -- 268,750
Shares issued at $1.25 per share in July 1989 as
compensation for services rendered -- -- -- 2,400
Shares issued by principal stockholders at $1.25
per share in December 1989 as compensation
for services rendered -- -- -- 374,000
Net loss for year ended December 31, 1989 (982,186) -- -- (982,186)
------------ ------------ ------------ ------------

Balance at December 31, 1989 (1,309,018) -- -- (309,842)

Shares issued by principal stockholder at $1.25
per share in March 1990 as compensation for
services rendered -- -- -- 56,250
Shares issued by principal stockholder at $.50 per
share in March 1990 as compensation for
services rendered -- -- -- 60,000
Shares issued at $1.67 per share in May 1990 as
compensation for services rendered -- -- -- 10,000
Shares issued at $1.67 per share, net of expenses of
$5,000 in March, April, November and December 1990 -- -- -- 645,000
Net loss for year ended December 31, 1990 (1,178,129) -- -- (1,178,129)
------------ ------------ ------------ ------------

Balance at December 31, 1990 (2,487,147) -- -- (716,721)

Shares issued at $1.67 per share from March
through November 1991 -- -- -- 525,000
Shares issued at $1.67 per share in November
1991 as compensation for services rendered -- -- -- 33,000
Net loss for year ended December 31, 1991 (1,009,368) -- -- (1,009,368)
------------ ------------ ------------ ------------

Balance at December 31, 1991 (carried forward) (3,496,515) -- -- (1,168,089)

See accompanying notes to consolidated financial statements.

F-6

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income- (Continued)

Class A Class B
common stock common stock
Shares Amount Shares Amount
------------ ------------ ------------ ------------

Balance at December 31, 1991 (brought forward) -- -- 5,982,720 59,827

Shares issued at $1.67 per share from January through
October 1992 -- -- 708,000 7,080
Shares issued at $1.67 per share in May 1992 in connection
with License and Cross-License Agreement -- -- 674,976 6,750
Shares issued at $1.67 per share in May 1992 as
compensation for services rendered -- -- 18,000 180
Shares issued at $2.50 per share in May and November
1992 as compensation for services rendered -- -- 771,000 7,710
Shares issued at $2.50 per share, net of expenses
of $7,500, in November and December 1992 -- -- 323,001 3,230
Shares issued by principal stockholder in
December 1992 at $2.50 per share as
compensation for services rendered -- -- -- --
Shares canceled in October and December 1992 -- -- (75,000) (750)
Issuance of stock options at $.003 exercise price
per share in June 1992 -- -- -- --
Amortization of deferred compensation -- -- -- --
Accrued dividends on preferred stock -- -- -- --
Note receivable and accrued interest from stockholder -- -- -- --
Net loss for the year ended December 31, 1992 -- -- -- --
------------ ------------ ------------ ------------
Balance at December 31, 1992 -- -- 8,402,697 84,027

Shares issued at $1.67 per share in February 1993 -- -- 30,000 300
Shares issued at $3.50 per share, net of expenses of
$82,427, from April through December 1993 -- -- 550,359 5,504
Shares issued at $3.50 per share from May to December
1993 as compensation for services rendered, for the
acquisition of property and equipment and as additional
interest on borrowings -- -- 73,319 733
Issuance of warrants to purchase Class B common stock
from September to December 1993 in conjunction with
the issuance of convertible debt -- -- -- --
Amortization of deferred compensation -- -- -- --
Accrued dividends on preferred stock -- -- -- --
Note receivable and accrued interest from stockholder -- -- -- --
Net loss for year ended December 31, 1993 -- -- -- --
------------ ------------ ------------ ------------
Balance at December 31, 1993 -- -- 9,056,375 90,564

Deficit
accumulated Note
Capital during the receivable
in excess of development Deferred from
par value stage compensation stockholder
------------ ------------ ------------ ------------

Balance at December 31, 1991 (brought forward) 2,268,599 (3,496,515) -- --

Shares issued at $1.67 per share from January through
October 1992 1,172,920 -- -- --
Shares issued at $1.67 per share in May 1992 in connection
with License and Cross-License Agreement 1,118,210 -- -- --
Shares issued at $1.67 per share in May 1992 as
compensation for services rendered 29,820 -- -- --
Shares issued at $2.50 per share in May and November
1992 as compensation for services rendered 1,919,790 -- -- --
Shares issued at $2.50 per share, net of expenses
of $7,500, in November and December 1992 796,773 -- -- --
Shares issued by principal stockholder in
December 1992 at $2.50 per share as
compensation for services rendered 75,000 -- -- --
Shares canceled in October and December 1992 750 -- -- --
Issuance of stock options at $.003 exercise price
per share in June 1992 798,400 -- (398,660) --
Amortization of deferred compensation -- -- 155,455 --
Accrued dividends on preferred stock (6,383) -- -- --
Note receivable and accrued interest from stockholder -- -- -- (152,974)
Net loss for the year ended December 31, 1992 -- (4,182,638) -- --
------------ ------------ ------------ ------------
Balance at December 31, 1992 8,173,879 (7,679,153) (243,205) (152,974)

Shares issued at $1.67 per share in February 1993 49,800 -- -- --
Shares issued at $3.50 per share, net of expenses of
$82,427, from April through December 1993 1,838,294 -- -- --
Shares issued at $3.50 per share from May to December
1993 as compensation for services rendered, for the
acquisition of property and equipment and as additional
interest on borrowings 255,884 -- -- --
Issuance of warrants to purchase Class B common stock
from September to December 1993 in conjunction with
the issuance of convertible debt 72,893 -- -- --
Amortization of deferred compensation -- -- 243,205 --
Accrued dividends on preferred stock (38,467) -- -- --
Note receivable and accrued interest from stockholder -- -- -- (39,783)
Net loss for year ended December 31, 1993 -- (3,959,334) -- --
------------ ------------ ------------ ------------
Balance at December 31, 1993 10,352,283 (11,638,487) -- (192,757)

Total
------------
Balance at December 31, 1991 (brought forward) (1,168,089)

Shares issued at $1.67 per share from January through
October 1992 1,180,000
Shares issued at $1.67 per share in May 1992 in connection
with License and Cross-License Agreement 1,124,960
Shares issued at $1.67 per share in May 1992 as
compensation for services rendered 30,000
Shares issued at $2.50 per share in May and November
1992 as compensation for services rendered 1,927,500
Shares issued at $2.50 per share, net of expenses
of $7,500, in November and December 1992 800,003
Shares issued by principal stockholder in
December 1992 at $2.50 per share as
compensation for services rendered 75,000
Shares canceled in October and December 1992 --
Issuance of stock options at $.003 exercise price
per share in June 1992 399,740
Amortization of deferred compensation 155,455
Accrued dividends on preferred stock (6,383)
Note receivable and accrued interest from stockholder (152,974)
Net loss for the year ended December 31, 1992 (4,182,638)
------------
Balance at December 31, 1992 182,574

Shares issued at $1.67 per share in February 1993 50,100
Shares issued at $3.50 per share, net of expenses of
$82,427, from April through December 1993 1,843,798
Shares issued at $3.50 per share from May to December
1993 as compensation for services rendered, for the
acquisition of property and equipment and as additional
interest on borrowings 256,617
Issuance of warrants to purchase Class B common stock
from September to December 1993 in conjunction with
the issuance of convertible debt 72,893
Amortization of deferred compensation 243,205
Accrued dividends on preferred stock (38,467)
Note receivable and accrued interest from stockholder (39,783)
Net loss for year ended December 31, 1993 (3,959,334)
------------
Balance at December 31, 1993 (1,388,397)

See accompanying notes to consolidated financial statements.

F-7

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income- (Continued)

Class A Class B
common stock common stock
Shares Amount Shares Amount
------------ ------------ ------------ ------------

Balance at December 31, 1993 -- -- 9,056,375 90,564

Shares issued at $3.50 per share in January and
February 1994 -- -- 95,715 957
Shares issued at $3.50 per share in February 1994
as additional interest on borrowings -- -- 5,700 57
Issuance of warrants to purchase Class B common stock in
January and February 1994 in conjunction with
the issuance of convertible debt -- -- -- --
Accrued dividends on preferred stock -- -- -- --
Accrual of interest on note receivable from stockholder -- -- -- --
Sale of warrants to underwriter in September 1994 -- -- -- --
Conversion of notes payable -- -- 599,507 5,995
Shares issued at $5.00 per share in initial public offering
in September 1994, net of expenses of $2,929,835 3,728,200 37,282 -- --
Net loss for year ended December 31, 1994 -- -- -- --
------------ ------------ ------------ ------------

Balance at December 31, 1994 3,728,200 37,282 9,757,297 97,573

Shares issued at prices ranging from $1.00 per share to
$3.13 per share as compensation for services rendered 31,559 315 -- --
Exercise of options to purchase Class B stock -- -- 681,700 6,817
Accrued dividends on preferred stock -- -- -- --
Accrual of interest on note receivable from stockholder -- -- -- --
Exchange of Class B stock for Class A stock 2,855,859 28,559 (2,855,859) (28,559)
Net loss for the year ended December 31, 1995 -- -- -- --
------------ ------------ ------------ ------------

Balance at December 31, 1995 6,615,618 66,156 7,583,138 75,831

Exercise of options to purchase Class A stock 214,091 2,141 -- --
Shares issued at prices ranging from $2.06 per share to
$3.44 per share as compensation for services rendered 42,077 421 -- --
Issuance of unregistered Class B common stock to acquire
Wave Interactive Network valued at approximately
$.98 per share -- -- 375,000 3,750
Issuance of warrants to purchase unregistered shares of
Class A common stock in conjunction with the issuance
of convertible debt and preferred stock -- -- -- --
Conversion of Class B Preferred Stock 2,960,303 29,603 -- --
Accrual of interest on note receivable -- -- -- --
Accrued dividends on preferred stock -- -- -- --
Exchange of Class B stock for Class A stock 1,749,997 17,500 (1,749,997) (17,500)
N*ABLE APIC in connection with the issuance of
Class A common stock due to merger 873,317 8,733 -- --
Net loss for the year ended December 31, 1996 -- -- -- --
------------ ------------ ------------ ------------

Balance at December 31, 1996 12,455,403 124,554 6,208,141 62,081
------------ ------------ ------------ ------------

Deficit
accumulated Note
Capital during the receivable
in excess of development Deferred from
par value stage compensation stockholder
------------ ------------ ------------ ------------

Balance at December 31, 1993 10,352,283 (11,638,487) -- (192,757)

Shares issued at $3.50 per share in January and
February 1994 334,046 -- -- --
Shares issued at $3.50 per share in February 1994
as additional interest on borrowings 19,893 -- -- --
Issuance of warrants to purchase Class B common stock in
January and February 1994 in conjunction with
the issuance of convertible debt 115,234 -- -- --
Accrued dividends on preferred stock (39,484) -- -- --
Accrual of interest on note receivable from stockholder -- -- -- (17,315)
Sale of warrants to underwriter in September 1994 4 -- -- --
Conversion of notes payable 2,079,131 -- -- --
Shares issued at $5.00 per share in initial public offering
in September 1994, net of expenses of $2,929,835 15,673,883 -- -- --
Net loss for year ended December 31, 1994 -- (4,271,501) -- --
------------ ------------ ------------ ------------

Balance at December 31, 1994 28,534,990 (15,909,988) -- (210,072)

Shares issued at prices ranging from $1.00 per share to
$3.13 per share as compensation for services rendered 57,184 -- -- --
Exercise of options to purchase Class B stock 429,413 -- -- --
Accrued dividends on preferred stock (40,600) -- -- --
Accrual of interest on note receivable from stockholder -- -- -- (17,318)
Exchange of Class B stock for Class A stock -- -- -- --
Net loss for the year ended December 31, 1995 -- (6,832,866) -- --
------------ ------------ ------------ ------------

Balance at December 31, 1995 28,980,987 (22,742,854) -- (227,390)

Exercise of options to purchase Class A stock 420,366 -- -- --
Shares issued at prices ranging from $2.06 per share to
$3.44 per share as compensation for services rendered 123,029 -- -- --
Issuance of unregistered Class B common stock to acquire
Wave Interactive Network valued at approximately
$.98 per share 364,688 -- -- --
Issuance of warrants to purchase unregistered shares of
Class A common stock in conjunction with the issuance
of convertible debt and preferred stock 283,455 -- -- --
Conversion of Class B Preferred Stock 3,078,921 -- -- --
Accrual of interest on note receivable -- -- -- (17,315)
Accrued dividends on preferred stock (199,014) -- -- --
Exchange of Class B stock for Class A stock -- -- -- --
N*ABLE APIC in connection with the issuance of
Class A common stock due to merger 1,296,241 -- -- --
Net loss for the year ended December 31, 1996 -- (10,126,546) -- --
------------ ------------ ------------ ------------

Balance at December 31, 1996 34,348,673 (32,869,400) -- (244,705)
------------ ------------ ------------ ------------

Total
------------
Balance at December 31, 1993 (1,388,397)

Shares issued at $3.50 per share in January and
February 1994 335,003
Shares issued at $3.50 per share in February 1994
as additional interest on borrowings 19,950
Issuance of warrants to purchase Class B common stock in
January and February 1994 in conjunction with
the issuance of convertible debt 115,234
Accrued dividends on preferred stock (39,484)
Accrual of interest on note receivable from stockholder (17,315)
Sale of warrants to underwriter in September 1994 4
Conversion of notes payable 2,085,126
Shares issued at $5.00 per share in initial public offering
in September 1994, net of expenses of $2,929,835 15,711,165
Net loss for year ended December 31, 1994 (4,271,501)
------------

Balance at December 31, 1994 12,549,785

Shares issued at prices ranging from $1.00 per share to
$3.13 per share as compensation for services rendered 57,499
Exercise of options to purchase Class B stock 436,230
Accrued dividends on preferred stock (40,600)
Accrual of interest on note receivable from stockholder (17,318)
Exchange of Class B stock for Class A stock --
Net loss for the year ended December 31, 1995 (6,832,866)
------------

Balance at December 31, 1995 6,152,730

Exercise of options to purchase Class A stock 422,507
Shares issued at prices ranging from $2.06 per share to
$3.44 per share as compensation for services rendered 123,450
Issuance of unregistered Class B common stock to acquire
Wave Interactive Network valued at approximately
$.98 per share 368,438
Issuance of warrants to purchase unregistered shares of
Class A common stock in conjunction with the issuance
of convertible debt and preferred stock 283,455
Conversion of Class B Preferred Stock 3,108,524
Accrual of interest on note receivable (17,315)
Accrued dividends on preferred stock (199,014)
Exchange of Class B stock for Class A stock --
N*ABLE APIC in connection with the issuance of
Class A common stock due to merger 1,304,974
Net loss for the year ended December 31, 1996 (10,126,546)
------------

Balance at December 31, 1996 1,421,203
------------

See accompanying notes to consolidated financial statements.

F-8

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income- (Continued)

Class A Class B
common stock common stock
Shares Amount Shares Amount
------------ ------------ ------------ ------------

Balance at December 31, 1996 12,455,403 124,554 6,208,141 62,081

Exercise of options to purchase Class A and B common stock 70,326 703 10,330 104
Shares issued at prices ranging from $1.00 per share
to $3.00 per share as compensation for services
rendered 126,885 1,269 -- --
Conversion of preferred stock into common stock 7,998,860 79,989 -- --
Issuance of Class A common stock and warrants to
purchase Class A common stock to Aladdin 500,000 5,000 -- --
Issuance of Class A common stock and warrants to
purchase Class A common stock 799,964 8,000 -- --
Reduction in note receivable -- -- -- --
Accrual of interest on note receivable -- -- -- --
Issuance of warrants to purchase Class A common stock
in conjunction with the issuance of preferred stock -- -- -- --
Accrued dividend on preferred stock including accretion
of assured incremental yield -- -- -- --
Assured incremental yield on issuance of Series F
convertible preferred stock and debt -- -- -- --
N*ABLE APIC in connection with the issuance of
Class A common stock due to merger 1,404,723 14,047 -- --
Net loss -- -- -- --
Exchange of Class B stock for Class A stock 1,796,518 17,965 (1,796,518) (17,965)
---------- ------------ --------- ------------

Balance at December 31, 1997 25,152,679 $ 251,527 4,421,953 $ 44,220

Exercise of options to purchase Class A common stock 77,558 775 151,180 --
Options issued to employees below fair market-value -- -- -- --
Exercise of warrants to purchase Class A common stock 1,652,770 16,528 -- --
Warrants to purchase Class A common stock
to be issued as part of technology licensing
agreement and issued to consultants for services -- -- -- --
Shares issued at prices ranging from $1.00 per share
to $5.00 per share as compensation for services
rendered 121,400 1,214 -- --
Reduction in note receivable -- -- -- --
Issuance of Series G Convertible Preferred stock and
Common stock warrants, net of issuance costs of $222,500 -- -- -- --
Assured incremental yield on issuance of Series G
convertible preferred stock and debt -- -- -- --
Accrual of interest on note receivable -- -- -- --
Accrued dividend on preferred stock including accretion
of assured incremental yield -- -- -- --
Conversion of Series G Preferred Stock 2,394,494 23,945 -- --
N*ABLE's APIC in connection with the issuance of
Class A common stock due to the merger 2,781 28 -- --
Net loss -- -- -- --
Adjustment for net loss of N*ABLE for the 1st six
months ended June 30,of 1998 -- -- -- --
Exchange of Class B stock for Class A stock 1,281,288 12,813 (1,281,288) (12,813)
---------- ------------ --------- ------------

Balance at December 31, 1998 30,682,970 $ 306,830 3,140,665 $ 31,407
---------- ------------ --------- ------------

Deficit
Accumulated Series G Note
Capital during the Convertible receivable
in excess of development Preferred from
par value stage Stock stockholder
------------ ------------ ------------ ------------

Balance at December 31, 1996 34,348,673 (32,869,400) -- (244,705)

Exercise of options to purchase Class A and B common stock 139,081 -- -- --
Shares issued at prices ranging from $1.00 per share
to $3.00 per share as compensation for services
rendered 304,227 -- -- --
Conversion of preferred stock into common stock 6,703,028 -- -- --
Issuance of Class A common stock and warrants to
purchase Class A common stock to Aladdin 3,834,000 -- -- --
Issuance of Class A common stock and warrants to
purchase Class A common stock 792,000 -- -- --
Reduction in note receivable -- -- -- 50,000
Accrual of interest on note receivable -- -- -- (17,319)
Issuance of warrants to purchase Class A common stock
in conjunction with the issuance of preferred stock 386,462 -- -- --
Accrued dividend on preferred stock including accretion
of assured incremental yield (1,372,984) -- -- --
Assured incremental yield on issuance of Series F
convertible preferred stock and debt 682,000 -- -- --
N*ABLE APIC in connection with the issuance of
Class A common stock due to merger 10,128,492 -- -- --
Net loss -- (18,012,635) -- --
Exchange of Class B stock for Class A stock -- -- -- --
------------ ------------ ------------ ------------

Balance at December 31, 1997 $ 55,944,979 $(50,882,035) $ -- $ (212,024)

Exercise of options to purchase Class A common stock -- -- 151,955
Options issued to employees below fair market-value 234,723 -- -- --
Exercise of warrants to purchase Class A common stock 3,945,740 -- -- --
Warrants to purchase Class A common stock
to be issued as part of technology licensing
agreement and issued to consultants for services 1,546,824 -- -- --
Shares issued at prices ranging from $1.00 per share
to $5.00 per share as compensation for services
rendered 647,274 -- -- --
Reduction in note receivable -- -- -- 75,000
Issuance of Series G Convertible Preferred stock and
Common stock warrants, net of issuance costs of $222,500 218,250 -- 1,809,250 --
Assured incremental yield on issuance of Series G
convertible preferred stock and debt 750,000 -- -- --
Accrual of interest on note receivable -- -- -- (12,318)
Accrued dividend on preferred stock including accretion
of assured incremental yield (858,863) -- 837,263 --
Conversion of Series G Preferred Stock 2,274,756 -- (2,298,701) --
N*ABLE's APIC in connection with the issuance of
Class A common stock due to the merger 59,182 -- -- --
Net loss -- (16,586,027) -- --
Adjustment for net loss of N*ABLE for the 1st six
months ended June 30,of 1998 -- 2,253,461 -- --
Exchange of Class B stock for Class A stock -- -- -- --
------------ ------------ ------------ ------------

Balance at December 31, 1998 $ 64,919,050 $(65,214,601) $ 347,812 $ (149,342)
------------ ------------ ------------ ------------

Total
------------
Balance at December 31, 1996 1,421,203

Exercise of options to purchase Class A and B common stock 139,888
Shares issued at prices ranging from $1.00 per share
to $3.00 per share as compensation for services
rendered 305,496
Conversion of preferred stock into common stock 6,783,017
Issuance of Class A common stock and warrants to
purchase Class A common stock to Aladdin 3,839,000
Issuance of Class A common stock and warrants to
purchase Class A common stock 800,000
Reduction in note receivable 50,000
Accrual of interest on note receivable (17,319)
Issuance of warrants to purchase Class A common stock
in conjunction with the issuance of preferred stock 386,462
Accrued dividend on preferred stock including accretion
of assured incremental yield (1,372,984)
Assured incremental yield on issuance of Series F
convertible preferred stock and debt 682,000
N*ABLE APIC in connection with the issuance of
Class A common stock due to merger 10,142,539
Net loss (18,012,635)
Exchange of Class B stock for Class A stock --
------------

Balance at December 31, 1997 $ 5,151,672

Exercise of options to purchase Class A common stock
Options issued to employees below fair market-value 234,723
Exercise of warrants to purchase Class A common stock 3,962,268
Warrants to purchase Class A common stock
to be issued as part of technology licensing
agreement and issued to consultants for services 1,546,824
Shares issued at prices ranging from $1.00 per share
to $5.00 per share as compensation for services
rendered 648,488
Reduction in note receivable 75,000
Issuance of Series G Convertible Preferred stock and
Common stock warrants, net of issuance costs of $222,500 2,027,500
Assured incremental yield on issuance of Series G
convertible preferred stock and debt 750,000
Accrual of interest on note receivable (12,318)
Accrued dividend on preferred stock including accretion
of assured incremental yield (21,600)
Conversion of Series G Preferred Stock --
N*ABLE's APIC in connection with the issuance of
Class A common stock due to the merger 59,210
Net loss (16,586,027)
Adjustment for net loss of N*ABLE for the 1st six
months ended June 30,of 1998 2,253,461
Exchange of Class B stock for Class A stock --
------------

Balance at December 31, 1998 $ 241,156
------------

See accompanying notes to consolidated financial statements.

F-9

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income - (Continued)

Class A Class B
common stock common stock
Shares Amount Shares Amount
------------ ------------ ------------ ------------

Balance at December 31, 1998 30,682,970 $ 306,830 3,140,665 $ 31,407

Net loss -- -- -- --

Unrealized gain on Marketable Securities -- -- -- --

Comprehensive income (loss)

Exercise of options to purchase Class A common stock 964,000 9,640
Warrants exercised to purchase Class A common stock 3,370,238 33,684 -- --
Shares Issued at $11.00 per share, net of issuance costs 2,090,405 20,904
Conversion of Bridge to Loan to purchase Class A common stock 787,349 7,874
Warrants to Purchase Class A common stock
For services rendered
Shares issued as compensation for services rendered 83,461 834 -- --
Accrual of interest on note receivable -- -- -- --
Conversion of Series G Preferred Stock 377,102 3,771 -- --
Accrued dividend on preferred stock -- -- -- --
Exchange of Class B stock for Class A stock 1,090,158 10,902 (1,090,158) (10,902)
------------ ------------ ------------ ------------

Balance at December 31, 1999 39,445,683 $ 394,457 2,050,507 $ 20,505

Shares issued at $34.00 per share, net of issuance costs 3,600,800 36,008 -- --
Shares issued in exchange for substantially all of
the assets of Indigo Networks, LLC at $19.30 per share 374,889 3749 -- --
Shares issued as compensation for services at $13.75 per share 7,879 79 -- --
Exercise of warrants to purchase class A common stock 319,692 3,197 -- --
Exercise of Options to purchase class A common stock 2,030,958 20,309 -- --
Compensation on Employee Options issued -- -- -- --
Exchange of Class B common stock for Class A common stock 1,271,296 12,713 (1,271,296) (12,713)
Repayment of note receivable from stockholder -- -- -- --
Unrealized gain (loss) on marketable securities
Net loss -- -- -- --
------------ ------------ ------------ ------------

Balance at December 31, 2000 47,051,197 $ 470,512 779,211 $ 7,792
============ ============ ============ ============

Deficit
Accumulated Series G Accumulated
Capital during the Convertible Other
in excess of development Preferred Comprehensive
par value stage Stock Income
------------ ------------ ------------ ------------

Balance at December 31, 1998 $ 64,919,050 $(65,214,601) $ 347,812 --

Net loss -- (28,052,572) --

Unrealized gain on Marketable Securities -- -- -- 2,860,500

Comprehensive income (loss) --

Exercise of options to purchase Class A common stock 1,622,431 -- -- --
Warrants exercised to purchase Class A common stock 6,707,894 -- -- --
Shares Issued at $11.00 per share, net of issuance costs 21,481,665 -- -- --
Conversion of Bridge to Loan to purchase Class A common stock 2,567,380 -- -- --
Warrants to Purchase Class A common stock
For services rendered 1,075,240
Shares issued as compensation for services rendered 1,149,486 -- -- --
Accrual of interest on note receivable -- -- --
Conversion of Series G Preferred Stock 344,041 -- (347,812) --
Accrued dividend on preferred stock (13,239) -- --
Exchange of Class B stock for Class A stock -- -- -- --
------------ ------------ ------------ ------------

Balance at December 31, 1999 $ 99,854,111 $(93,267,173) $ 0 $ 2,860,500

Shares issued at $34.00 per share, net of issuance costs 114,941,407 -- -- --
Shares issued in exchange for substantially all of
the assets of Indigo Networks, LLC at $19.30 per share 7,231,609 -- -- --
Shares issued as compensation for services at $13.75 per share 108,254 -- -- --
Exercise of warrants to purchase class A common stock 1,331,048 -- -- --
Exercise of Options to purchase class A common stock 4,950,872 -- -- --
Compensation on Employee Options issued 318,609 -- -- --
Exchange of Class B common stock for Class A common stock -- -- -- --
Repayment of note receivable from stockholder -- -- -- --
Unrealized gain (loss) on marketable securities (937,196)
Net loss -- (47,655,893) -- --
------------ ------------ ------------ ------------

Balance at December 31, 2000 $228,735,911 $(140,923,066) $ 0 $ 1,923,304
============ ============ ============ ============

Note
receivable
from
stockholder Total
------------ ------------

Balance at December 31, 1998 $ (149,342) $ 241,156

Net loss -- (28,052,572)

Unrealized gain on Marketable Securities -- 2,860,500

Comprehensive income (loss) -- (25,192,072)

Exercise of options to purchase Class A common stock -- 1,632,071
Warrants exercised to purchase Class A common stock -- 6,741,759
Shares Issued at $11.00 per share, net of issuance costs -- 21,502,569
Conversion of Bridge to Loan to purchase Class A common stock -- 2,575,254
Warrants to Purchase Class A common stock
For services rendered 1,075,240
Shares issued as compensation for services rendered -- 1,150,320
Accrual of interest on note receivable (4,818) (4,818)
Conversion of Series G Preferred Stock -- --
Accrued dividend on preferred stock -- (13,239)
Exchange of Class B stock for Class A stock -- --
------------ ------------

Balance at December 31, 1999 $(154,160) $9,708,240

Shares issued at $34.00 per share, net of issuance costs -- 114,977,415
Shares issued in exchange for substantially all of
the assets of Indigo Networks, LLC at $19.30 per share -- 7,235,358
Shares issued as compensation for services at $13.75 per share - 108,333
Exercise of warrants to purchase class A common stock -- 1,334,245
Exercise of Options to purchase class A common stock -- 4,971,181
Compensation on Employee Options issued -- 318,609
Exchange of Class B common stock for Class A common stock -- --
Repayment of note receivable from stockholder 154,160 154,160
Unrealized gain (loss) on marketable securities -- (937,196)
Net loss -- (47,655,893)
------------ ------------

Balance at December 31, 2000 $ 0 $ 90,214,452
============ ============

See accompanying notes to consolidated financial statements.

F-10

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Consolidated Statements of Cash Flows
Years ended December 31, 2000, 1999, 1998 and the Period
From February 12, 1988 (Date of Inception) through December 31, 2000

Period from
February 12, 1988
(date of inception)
through
December 31,
2000 1999 1998 2000
---- ---- ---- ----

Cash flows from operating activities:
Net loss $(47,655,893) $(28,052,572) $(16,586,027) $(140,923,066)
Adjustments to reconcile net loss to net cash
used in operating activities:
Write-off of goodwill -- -- -- 769,886
Goodwill Amortization 573,544 -- -- 573,544
Depreciation and amortization 2,593,593 767,993 487,155 5,100,100
Reserve for note from affiliate -- -- -- 1,672,934
Accrued interest on marketable securities -- -- -- (106,962)
Non-cash expenses:
Accretion of assured incremental yield on
convertible debt -- -- -- 119,000
Common stock issued in connection with
License and Cross-License Agreement -- -- -- 1,124,960
Realized gain on marketable securities (542,457) -- -- (542,457)
Net losses realized on Global Wave investment 3,406,491 -- -- 3,406,491
Common stock issued for services rendered
and additional interest on borrowings 108,333 150,320 648,488 3,600,199
Warrants issued as compensation for services -- 1,075,240 1,552,235 2,751,595
Issuance of warrants to Aladdin -- -- -- 2,939,000
Accrued interest on note payable -- 15,388 39,707 121,219
In Process research and development 2,176,000 -- -- 2,176,000
Preferred stock issued for services rendered -- -- -- 265,600
Compensation associated with issuance of
stock options 318,609 -- 234,723 953,072
Amortization of deferred compensation -- -- -- 398,660
Amortization of discount on notes payable -- -- -- 166,253
Common stock issued by principal stockholder
for services rendered -- -- -- 565,250
Changes in assets and liabilities:
Increase (decrease) in deferred revenue -- (1,250,000) 1,250,000 56,926
Increase in accrued interest on note receivable -- (4,818) (12,318) (105,986)
(Increase) in inventories (193,462) (431,686) -- (625,148)
(Increase) decrease in prepaid expenses and
other receivables (194,834) (424,358) (67,500) (686,692)
(Increase) decrease in other assets (870,604) (243,833) (37,241) (1,292,440)
Increase in accounts payable and
accrued expenses 1,046,365 3,345,840 1,695,479 8,050,594
------------ ------------ ------------ -------------
Net cash used in operating activities (39,234,315) (25,052,486) (10,795,299) (109,471,468)
------------ ------------ ------------ -------------

(Continued)

F-11

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Consolidated Statements of Cash Flows (Continued)

Years ended December 31, 2000, 1999, 1998 and the Period
From February 12, 1988 (Date of Inception) through December 31, 2000

Period from
February 12, 1988
(date of inception)
through
December 31,
2000 1999 1998 2000
---- ---- ---- ----

Cash flows from investing activities:
Acquisition of property and equipment (3,829,300) (2,106,639) (590,619) (8,787,156)
Investment in Global Wave joint venture (4,142,000) -- -- (4,142,000)
Purchase of intangible assets (1,770,000) (1,750,000) -- (3,520,000)
Short-term loans to affiliate -- -- -- (1,672,934)
Organizational costs -- -- -- (14,966)
Proceeds from sale of marketable securities 2,162,457 -- -- 2,162,457
Exercise of warrant to acquire marketable
securities-available for sale -- (1,620,000) -- (29,166,769)
Maturity of marketable securities -- -- -- 27,653,731
------------- ------------ ------------ -------------

Net cash used in investing
activities (7,578,843) (5,476,639) (590,619) (17,487,637)
------------- ------------ ------------ -------------

Cash flows from financing activities:
Net proceeds from issuance of common stock 121,072,843 30,874,435 10,644,264 191,737,168
Net proceeds from issuance of preferred stock
and warrants -- -- 2,777,500 12,283,027
Note receivable from stockholder 154,160 -- 75,000 105,985
Proceeds from notes payable and warrants to
Stockholders -- 2,000,000 -- 4,083,972
Repayments of notes payable to stockholders -- -- -- (1,069,972)
Proceeds from notes payable and warrants -- -- -- 1,284,255
Repayments of note payable -- -- -- (255,000)
Redemption of Preferred Stock -- (506,440) -- (506,440)
------------- ------------ ------------ -------------

Net cash provided by financing activities 121,227,003 32,367,995 13,496,764 207,662,995
------------- ------------ ------------ -------------

Net increase in cash and cash equivalents 74,413,845 1,838,870 2,110,846 80,703,890

Cash and cash equivalents at beginning of period 6,290,045 4,451,175 2,340,329 --
------------- ------------ ------------ -------------

Cash and cash equivalents at end of period $ 80,703,890 $ 6,290,045 $ 4,451,175 $ 80,703,890
============= ============ ============ =============

Supplemental information about noncash investing and financing activities:

For the year ended December 31, 2000, additional common stock was issued
to acquire substantially all of the assets of Indigo Networks, LLC for
$7,445,358, including acquisition costs of $210,000.

See accompanying notes to consolidated financial statements.

F-12

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)

Notes to Consolidated Financial Statements

December 31, 2000, 1999, 1998 and the Period From February 12, 1988
(Date of Inception) Through December 31, 2000

(1) Business of the Company

Wave Systems Corp. (the "Company" or "Wave") is engaged in the research
and development of a proprietary system (the "Wave System") for use with a
computer, that measures, controls, and records the use of electronic
content. The Company is also engaged in various research, development and
marketing efforts to commercialize the Wave System to provide more
efficient and flexible pricing (e.g., pay per use or rent-to-own) and
greater security on the usage of the electronic content. The Company is in
the development stage and, accordingly, the accompanying consolidated
financial statements are presented in a format prescribed for a
development stage enterprise.

The Company has incurred significant losses in current and prior periods.
Management intends to continue to devote resources toward the research,
development and marketing of its products in order to generate future
revenues from licensing and product sales as well as develop the business
of WaveXpress. In addition, the Company is actively pursuing additional
short- and long-term financing sources, including debt and equity
financing. On March 8, 2000 the Company completed an offering of common
stock for net proceeds of approximately $114.9 million. Management
anticipates that the proceeds of this offering will be sufficient to fund
operations through the end of 2001. However, while management believes
that it can successfully develop and market its products and obtain
additional financing to fund operations beyond 2001, there can be no
assurance that it will be able to do so.

(2) Significant Accounting Policies

(a) Basis of Consolidation

The consolidated financial statements include the financial statements of
Wave; Wave Systems Holdings, Inc., a wholly owned subsidiary and a
majority-owned subsidiary, WaveXpress. All significant intercompany
balances and transactions have been eliminated in consolidation.

(b) Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of expenses during the
reporting period. Actual results could differ from those estimates.

(c) Method of Accounting for Joint Ventures

WaveXpress

In April 1999, the Company established WaveXpress as the basis for a joint
venture agreement with Sarnoff Corporation ("Sarnoff") to create
technology that allows broadcasters to transmit enhanced television, rich
media and Internet content to a variety of devices including digital
televisions (DTV's) and PC's. The Company owns 53% of the joint venture,
certain Wave employees (including Peter and Steven Sprague) and members of
its Board of Directors own 7%; and Sarnoff owns 40%. The Company has
provided technology and capital in the form of convertible notes totaling
$16.8 million

(Continued)

F-13

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

as of December 31, 2001. The Company has also committed to providing up to
an additional $4.7 million under these convertible notes. Sarnoff has
provided technology, but has not provided any funding to the venture. For
purposes of these consolidated financial statements, the Company has
consolidated 100% of the financial statements of WaveXpress. No minority
interest in the losses of WaveXpress has been recorded as the minority
owners are not obligated to fund the losses of WaveXpress. (See note 12.)

Global Wave, Ltd

In June 2000, the Company increased its ownership percentage of Globalwave
Limited ("Global Wave"), from 25% to 40%. (See note 12). On October 10,
2000, Wave entered into an agreement with Global Wave and its Joint
Venture partner Redwave, Plc. (formerly Internet Technologies Group, Plc.,
"ITG") to subscribe for additional shares to maintain a 40% ownership
interest in the venture. As consideration for the additional shares, Wave
committed to invest approximately $5.7 million in cash and development
services.

Wave accounts for its investment in Global Wave using the equity method of
accounting, and accordingly recognizes its share (40%) of Global Wave's
results of operations in the accompanying consolidated statement of
operations. (See note 12)

(d) Cash Equivalents

For purposes of the consolidated statements of cash flows, the Company
considers all highly liquid instruments with an original maturity of three
months or less to be cash equivalents.

(e) Marketable Securities

Debt securities and publicly traded equity securities are classified as
available for sale and are recorded at market using the specific
identification method. Unrealized gains and losses are reflected in other
comprehensive income. All other investments, excluding joint venture
arrangements, are recorded at cost.

(f) Inventories

Inventories, which are stated at the lower of cost or net realizable
value, consist of inventory held for resale to customers. Cost is
determined on the first-in, first-out basis; and includes freight and
other incidental costs incurred.

(g) Property and Equipment

Property and equipment, including computer software, are stated at cost.
Depreciation is computed using the straight-line method over estimated
useful lives of three to five years less accumulated depreciation.

(h) Goodwill and acquisition intangibles

Goodwill, which represents the excess of purchase price over the fair
value of net assets acquired, is amortized on a straight-line basis over
the period expected to be benefited (currently 2 to 3 years). The Company
assesses the recoverability of this intangible asset by determining
whether the amortization of the goodwill balance over its remaining life
can be recovered through undiscounted future operating cash flows of the
related acquired operation. The amount of goodwill impairment, if any, is
measured based on projected discounted future operating cash flows using a
discount rate

(Continued)

F-14

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

reflecting the Company's average cost of funds. The assessment of the
recoverability of goodwill is impacted if estimated future operating cash
flows are not achieved.

(i) Income Taxes

The Company accounts for income taxes under the asset and liability
method. As such, deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities
and their respective tax bases and operating loss and tax credit
carryforwards. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled.
The effect on deferred tax assets and liabilities of a change in tax rates
is recognized in income in the period that includes the enactment date.

(j) Stock Option Plan

The Company accounts for its stock option plans in accordance with the
provisions of Accounting Principles Board ("APB") Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations. As
such, compensation expense is recorded on the date of grant only if the
current market price of the underlying stock exceeds the exercise price.
The Company adopted the disclosure provisions of Statement of Financial
Accounting Standards ("SFAS") No. 123, Accounting for Stock Based
Compensation and accordingly, provides pro forma net income and pro forma
earnings per share footnote disclosures for employee stock options as if
the fair value-based method defined in SFAS No. 123 had been applied.

(k) Research and Development

Research and development costs are expensed as incurred. Software
development costs are required to be capitalized when a product's
technological feasibility has been established either by completion of a
detailed program design or a working model of the product and ending when
a product is available for general release to consumers. Technological
feasibility of the Company's product has not yet been established, and as
a result, no software development costs have been capitalized.

(l) Loss Per Share

Basic net loss per common share has been calculated based upon the
weighted average number of shares of common stock outstanding during the
period. No effect has been given to common stock equivalents or
convertible preferred stock, warrants or convertible debt in the diluted
loss per common share as they are all anti-dilutive.

(m) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of

The Company reviews its long-lived assets and certain identifiable
intangibles for impairment whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison
of the carrying amount of an asset to future net cash flows expected to be
generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the

(Continued)

F-15

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

carrying amount of the assets exceed the fair value of the assets. Assets
to be disposed of are reported at the lower of the carrying amount or fair
value less costs to sell.

(3) Business Combinations

(a) Pooling of Interest Combination

The accompanying consolidated financial statements of Wave Systems Corp.
and subsidiaries ("Wave" or the "Company") have been prepared to give
effect to the acquisition of N*Able Technologies, Inc. ("N*Able"), which
was acquired on July 27, 1999. The acquisition was effected through the
issuance of 2,280,821 shares of Class A Common Stock in exchange for all
the shares of N*Able and was accounted for pursuant to the
pooling-of-interests method of accounting. N*Able was a Massachusetts
based company that produced hardware-based security solutions for the
protection of sensitive user data within network client systems, including
a hardware-based security co-processor that manages the secure transfer of
sensitive payment, personal information to and from desktop computers. The
fiscal year end for N*Able was June 30. In preparing these consolidated
financial statements, the calendar 1999 and 1998 financial statements of
the Company were combined with the financial statements of N*Able for the
same twelve month periods.

The following table shows the historical results for the periods of and
prior to the merger:

Years-ended December 31,
-------------------------------------
1999 1998
------------- --------------
Net Loss
Wave $(22,592,000) $(11,895,944)
N*Able (5,460,572) (4,690,083)
------------ ------------
Combined $(28,052,572) $(16,586,027)

(b) Purchase Acquisition

On August 31, 2000, the Company purchased substantially all of the assets
of Indigo Networks, LLC ("Indigo") and its e-commerce shopping network,
iShopHere.com. The aggregate purchase price totaled $7,445,000, which
consisted of 374,889 shares of Class A Common Stock priced at $19.30 per
share, for a total value of $7,235,000 plus transaction costs of $210,000.
The purchase price was based on the average closing price of the Company's
Class A Common Stock for the ten trading days immediately preceding the
date of the purchase, in accordance with the purchase agreement. The
following is a summary of the allocation of the purchase price:

Purchase consideration $ 7,235,358
Direct Acquisition costs 210,000
------------
Total Purchase Price $ 7,445,358
Less tangible and intangible assets acquired:
Fair market value of tangible assets 691,612
------------
In-Process R&D 2,176,000
------------
4,578,746
Goodwill & other intangible assets:
Developed Technology $ 779,000
Assembled Work force 310,000
Contracts 77,300
Excess over identifiable assets 3,412,446
------------
Goodwill and other acquisition intangible assets $ 4,578,746

(Continued)

F-16

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

The amount allocated to in-process research and development totaling
$2,176,000 was determined using established valuation techniques and was
expensed upon acquisition as technological and/or commercial feasibility
had not been established. The amount allocated to goodwill and purchased
intangible assets amounted to $4,578,000 and is being amortized on a
straight-line basis over periods not exceeding three years.

In conjunction with the purchase, the Company loaned $1,000,000 to the
partners of Indigo which was to be used by Indigo to pay existing accounts
payable and to cover operations up to the date of the purchase. On October
24, 2000, Indigo's successor, Blue Windup, LLC signed a promissory note
for the outstanding balance owed to the Company. The note carried an
interest rate of 2% above the prime rate published in The Wall Street
Journal. The note was paid in full in December 2000.

The consolidated financial statements include the operating results of
iShopHere.com from the date of acquisition, which consisted of a net loss
of approximately $846,000. The selected unaudited pro forma condensed
consolidated financial information presented below has been derived from
the audited and unaudited historical financial statements of Wave and
Indigo, and reflects management's estimate of pro forma adjustments. This
pro forma presentation does not purport to represent what our results of
operations would actually have been if such transactions and events had in
fact occurred on those dates or to project our results of operations for
any future period. The unaudited pro forma consolidated statements of
operations give effect to the acquisition of Indigo as if it had occurred
on January 1, 1999.

Dollars in thousands except per share data 2000 1999
-------- --------
Net revenues $ 372 $ 220
Net loss (50,363) (34,860)
Net loss per share $ (1.08) $ (0.90)

(Continued)

F-17

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

(4) Related Party Transactions

(a) Notes Receivable from Stockholder

A stockholder, the Chairman and former Chief Executive Officer of the
Company, was indebted to the Company at December 31, 1999 under promissory
notes totaling $154,160, including accrued interest, which were due on
demand. The entire remaining loan balance was repaid in March, 2000.

The note was secured by a pledge of 67,000 shares of Class B Common Stock
held by the stockholder. The notes bore interest at 10% per annum. The
note and accrued interest thereon had been shown as a deduction from
stockholders' equity in the accompanying consolidated financial
statements.

(b) Payments to Related Party

In 1997, the Company paid $182,209 to Enterprise Engineering Associates
("EEA"), during which time Mr. Michael Sprague was an employee of EEA. On
August 1, 1997, Michael Sprague became an employee of Wave, at an annual
salary of $110,000. On November 1, 1999 he became an employee of
WaveXpress at an annual salary of $120,000. Michael Sprague is the son of
the Chairman and former Chief Executive Officer of the Company

In 1998, the Company paid $25,000 to Studio 2, during which time Mr. Kevin
Sprague was an employee of Studio 2. Kevin Sprague is the son of the
Chairman and CEO of the Company.

(c) Acquisition and Dispositions

In November 1995, the Company entered into a transaction with certain
individuals whereby shares in its newly-formed subsidiary, Wave
Interactive Network, Inc. ("WIN"), were transferred in exchange for a
demand note. The amount of the demand note was based on the level of
funding provided to WIN by the Company during 1995. The demand note from
WIN accrued interest at a rate of Prime plus 1% and, subject to certain
limitations associated with WIN's ability to raise additional capital, was
convertible into an undiluted 20% of the common shares of WIN at the
option of Wave. The Company retained a 1% ownership in WIN and transferred
the remaining ownership to certain individuals, including former
employees. Approximately 65% of the ownership was transferred to Steven
Sprague, President and CEO of WIN, and three other children of Mr. Peter
J. Sprague, Chairman and former CEO of Wave. The note was fully reserved
as its collectibility was dependent upon WIN's ability to raise additional
capital. In addition, the Company entered into a separate commercial
agreement that, among other things, granted certain distribution rights to
WIN in exchange for royalties and other consideration.

During 1996, the Company continued to finance the operations of WIN
through additional demand notes with terms similar to the original demand
note. The additional notes amounting to $1,004,000 were also fully
reserved. On December 30, 1996, effective as of October 18, 1996, the
Company entered into a merger agreement with WIN whereby the Company
exchanged, for all of the outstanding WIN common stock that it did not
own, 375,000 shares of Class B Common Stock. These Class B shares are
restricted securities within the meaning of Rule 144 of the Securities Act
of 1933, as amended (the "Act"). Additionally, based on the attainment of
a specified milestone, the shareholders of WIN were entitled to receive an
additional 325,000 shares of the Company's Class B Common Stock. During
1999, the time to attain the milestone had expired as did the entitlement
to additional shares and no additional shares were issued. The Company
also issued a 10% convertible note and a warrant to refinance a
convertible note obligation of WIN amounting to approximately $456,000,
which included accrued interest to October 18, 1996, and an outstanding
warrant. Included

(Continued)

F-18

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

in the results of operations are WIN's operations from October 18, 1996.
The acquisition was accounted for by the purchase method.

The purchase price of $952,438 was determined based on the estimated fair
value of the consideration given to the WIN shareholders and noteholders
and was allocated to goodwill as WIN had no net tangible assets.
Subsequently, in 1997, the Company determined it was uncertain whether the
current and expected future results of operations of WIN would be adequate
to support the goodwill capitalization, and wrote-off the goodwill as
impaired.

(d) WaveXpress

In April 1999, the Company established WaveXpress as the basis for a joint
venture agreement with Sarnoff Corporation ("Sarnoff"). The joint venture
is owned 53% by the Company and 7% by certain of its affiliates, including
Peter and Steven Sprague and certain Wave employees and members of the
Board of Directors and 40% by Sarnoff and its affiliates. The Company has
committed to provide technology and capital in the form of a series of
convertible notes for an amount up to $15.5 million plus accrued interest;
and Sarnoff will provide technology, but will not provide any financing.
As of December 31, 2000 the total amount outstanding on the convertible
notes was $16,793,000, including $988,000 of accrued interest. These
amounts have been eliminated in consolidation.

For the years-ended December 31, 2000, 1999 and 1998, the Company incurred
expenses for consulting and travel, payable to Sarnoff of approximately
$924,000, $701,000 and $0, respectively. Payments made to Sarnoff for the
years-ended December 31, 2000, 1999 and 1998 were $986,000, $356,000 and
$0, respectively. As of December 31, 2000 and 1999, the Company had
accounts payable to Sarnoff of $325,000 and $359,000, respectively

(5) Property and Equipment

Property and equipment as of December 31 consisted of the following:

2000 1999
---- ----

Equipment $ 5,253,854 $ 2,856,730
Furniture, fixtures and improvements 1,919,219 534,987
Computer software 2,237,225 1,528,990
----------- ---------
9,410,298 4,920,707
Less: Accumulated depreciation 4,208,429 2,239,834
----------- ----------
Total $ 5,201,869 $ 2,680,873
=========== ==========

Depreciation expense on property and equipment amounted to approximately
$1,969,000, $768,000, $487,000 and $4,475,000 for the years ended December
31, 2000, 1999, and 1998 and for the period from inception through
December 31, 2000, respectively.

(Continued)

F-19

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

(6) Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses as of December 31 consisted of the
following:

2000 1999
----------- ----------

Accrual of costs related to the ITG agreement $ 490,000 $ 490,000
Accounts payable 4,403,424 4,058,043
Accrued consulting and professional fees 553,428 743,000
Accrued payroll and related costs 1,480,346 1,110,000
Lease payable 144,054 20,472
Annual Report and Shareholders Meeting 133,155 150,000
Franchise Tax Payable 225,000 --
Other accrued liabilities 440,602 252,125
----------

Total $ 7,870,009 $6,823,643
=========== ==========

(7) Capital Stock

(a) Redeemable Preferred Stock

The Company has authorized 2,000,000 shares of preferred stock having a
par value of $.01 per share. On October 19, 1992, the Board of Directors
designated and issued 360 shares of this preferred stock of the Company as
"Series A Cumulative Redeemable Preferred Stock" ("Series A Preferred
Stock").

The Series A Preferred Stock was issued in settlement of compensation owed
to a former officer of the Company for services provided to the Company.
The holder of the Series A Preferred Stock was entitled to receive a
dividend at the rate of $60 per share per annum, when and as declared by
the Board of Directors of the Company. Dividends were cumulative from the
date of original issue, and payable upon redemption. On August 11, 1999,
the Company redeemed these shares for a total payment of $506,440,
including accrued and unpaid dividends.

In May of 1996, the Company raised $3,214,026, net of issuance costs of
$285,974, through the placement of 350 shares of Series B Preferred Stock
("Series B Preferred Stock") pursuant to Regulation S of the Securities
Act of 1933 ("the Act"). The Series B Preferred Stock had a stated value
of $10,000 per share, accrued dividends for liquidation and conversion
purposes at 6% per annum and ranked senior to the Company's Common Sock
and Series C Convertible Preferred Stock ("Series C Preferred Stock") and
junior to the Series A Preferred Stock. Series B Preferred Stock was
convertible by the holder, in increments, into the Company's Class A
common stock. The Series B Preferred Stock was convertible at the lesser
of 110% of the average closing bid price for the five days immediately
preceding the issue date or 85% of the average closing bid price for the
five days immediately preceding the conversion date.

During 1996, 330 shares of the Company's Series B Preferred Stock were
converted into 2,960,303 shares of the Company's Class A Common Stock and
the remaining 20 shares of Series B Preferred Stock were converted in 1997
into 117,240 shares of the Company's Class A Common Stock.

In December of 1996, the Company raised $2,634,037 net of issuance costs
of $365,963 ($101,964 of which related to the value ascribed to warrants
issued) through the placement of 150,000 shares of Series C Preferred
Stock pursuant to Regulation D of the Act. The Series C Preferred Stock
had a stated value of $20 per share, which accrued dividends payable
quarterly in cash at 6% per annum.

(Continued)

F-20

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

The Series C Preferred Stock ranked senior to the Company's Common Stock
and junior to the Series A and B Preferred Stock. Series C Preferred Stock
was convertible by the holder, in increments, into the Company's Class A
Common Stock based on the market price of the Company's Class A Common
Stock at the time of conversion. The Series C Preferred Stock was
convertible at the lesser of $2.31 per share or 80%, as adjusted, of the
average of the fair value of the Class A Common Stock for the five days
prior to the conversion date. During 1997 all of the Series C Preferred
Stock was converted into 2,850,439 shares of the Company's Class A Common
Stock.

In May of 1997 the Company raised approximately $1,316,000, net of
issuance costs of $272,000 ($162,000 of which related to the value
ascribed to warrants issued), through the placement of 80,000 shares of
newly created Series D Convertible Preferred Stock. The Series D Preferred
Stock had a stated value of $20 per share, which accrued dividends payable
quarterly in cash at 6%.

The Series D Convertible Preferred Stock was convertible into the Class A
Common Stock of the Company at an effective conversion price of the lower
of (i) $1.35, or (ii) 80% of the average closing bid price on the NASDAQ
National Market System of the Company's Class A Common Stock for the five
(5) trading days immediately preceding the date of conversion. During 1997
all of the Series D Convertible Preferred Stock was converted into
2,070,095 shares of the Company's Class A Common Stock.

(b) Convertible Preferred Stock

In October 1997 the Company raised approximately $1,850,000, net of
issuance costs of $397,000 ($224,000 of which related to the value
ascribed to warrants issued), through the private placement of 112,500
shares of newly created Series F Convertible Preferred Stock. The Series F
Convertible Preferred Stock had a stated value of $20 per share, which
accrued dividends payable quarterly in cash at 6%. The Series F
Convertible Preferred Stock was convertible into the Class A Common Stock
at an effective conversion price of the lower of (a) $1.05 and (b) 80% of
the average of the five (5) lowest trading prices of Class A Common Stock.
During 1997 all of the Series F Convertible Preferred Stock was converted
into 2,961,086 shares of the Company's Class A Common Stock.

During March of 1998, the Company issued 150,000 shares of newly created
Series G Convertible Preferred Stock for an aggregate purchase price of
$3,000,000. The Series G Convertible Preferred Stock was senior to the
Company's classes of Common Stock, and was junior to the Company' Series A
Preferred Stock in liquidation rights. The Series G Convertible Preferred
Stock accrued dividends at the rate of 6% per annum. The Series G
Convertible Preferred Stock was convertible into the Company's
unregistered Class A Common Stock at the lower of $1.12 or 80% of the
average of the five lowest closing bids for the 25 calendar days prior to
conversion. In addition, the Company issued warrants to the purchaser and
placement agent for 225,000 shares of the Company's Class A Common Stock
at an exercise price of $1.38. The Series G Convertible Preferred Stock
was converted into 2,394,494 and 377,102 shares of the Company's Class A
Common Stock during 1998 and 1999, respectively.

(c) Common Stock

In December 1989, March through October 1990, and November 1991,
substantially all stockholders as of December 29, 1989 were offered the
right to acquire a number of shares equivalent to their pre-offering
holdings at a price of $.003 per share. Substantially all stockholders
that received the offer accepted this offer. This was accounted for
essentially as a stock split effected in the form of a rights offering,
and all shares issued in conjunction with this offering were reflected in
the accompanying consolidated financial statements retroactively.

(Continued)

F-21

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

Two principal stockholders did not acquire the full amount of shares to
which they were entitled. Most of the additional proportionate shares that
these stockholders would have been credited with were offered instead to
certain officers, employees and stockholders for $.003 per share. To the
extent that these rights were offered to the individuals in compensation
for services rendered to the Company, compensation expense equal to the
difference between the estimated fair value as of the date of issuance and
the purchase price of the stock was recorded. The estimated fair value of
the Common Stock was determined based on sales to third parties near the
date of issuance. Compensation expense associated with the issuance of
these shares of $430,250 is included in the accompanying consolidated
statement of operations for the period from inception to December 31,
2000.

In May and November, 1992, the Company issued 770,000 shares of Class B
restricted Common Stock to certain employees, officers and stockholders of
the Company for a purchase price of $.003 per share, payable in the form
of services to the Company. As these shares were issued for services
rendered, compensation expense of $1,927,500 was recorded representing the
estimated fair value of $2.50 per share at the date of issuance, the price
at which Common Stock was sold to third parties near the time of issuance.

In February 1995, the Company agreed to grant 36,000 shares of Class A
Common Stock, 12,000 of which were issued in 1995 with the remainder
issued in 1996, to two consultants and six non-employee directors as
compensation for services rendered. Expenses of $112,500 were recorded in
1995 representing the stock's fair value of $3.13 per share at the time of
the agreement to grant.

In July 1995, the Company issued 19,559 shares to two vendors in payment
for services rendered. Costs of $20,000 were recorded representing the
stock's fair value of approximately $1.00 per share at the time the
services were rendered.

In July and August 1996, the Company issued 15,000 and 3,077 shares of
Class A Common Stock to two consultants as compensation for services
rendered. Expenses of $40,938 have been recorded representing the stock's
fair value of $2.06 and $3.44 per share, respectively, at their dates of
issuance.

During 1997 the Company issued 126,885 shares of the Company's Class A
Common Stock to vendors or for the settlement of liabilities. Expenses of
$305,496 have been recorded representing the stocks' fair value at the
date of issuance.

During 1997 the Company sold approximately 800,000 shares of the Company's
Class A Common Stock and warrants to purchase 160,000 shares of the
Company's Class A Common Stock, exercisable at an exercise price of $1.00,
for an aggregate purchase price of $800,000. The warrants were exercised
or expired during 1999.

During 1997 the Company issued 500,000 shares of the Company's Class A
Common Stock in connection with a license agreement with Aladdin Knowledge
Systems, Ltd. for its proprietary persistent encryption technology. The
shares were issued at their fair value on the date of issuance.

On March 23, 1999, the Company sold 2,090,954 shares of its Class A Common
Stock at a price of $11.00 per share, for an aggregate purchase price of
$23,000,494. These shares were sold to a group of accredited investors
pursuant to Regulation D promulgated under the securities act of 1933, as
amended. Pacific Growth Equities, Inc. acted as sole placement agent for
the private placement, receiving a commission of 6% or approximately $1.2
million for their services.

On March 7, 2000 the Company sold 3,600,800 shares of its Class A Common
Stock at a price of $34.00 per share, for an aggregate purchase price of
$122,427,200. The shares were sold to a group

(Continued)

F-22

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

of accredited investors pursuant to regulation D promulgated under the
securities act of 1933, as amended. Pacific Growth Equities, Inc. acted as
sole placement agent for the private placement, receiving a commission of
6% or approximately $7.3 million for their services.

(d) Recapitalization

In January 1994, the Board of Directors authorized the Company to amend
and restate the Company's Certificate of Incorporation to reflect the
authorization of 25,000,000 shares of a newly created Class A Common
Stock, which stock has voting rights of one vote per share, and the
reclassification of the then current outstanding shares of Common Stock
into Class B Common Stock. In June 1994, the Board of Directors authorized
that the Class B Common stock will have one vote per share, except that
Class B Common Stock will have five votes per share in cases where one or
more directors are nominated for election by persons other than the
Company's Board of Directors and where there is a vote on any merger,
consolidation or other similar transaction, which is not recommended by
the Company's Board of Directors. In addition, the Class B Common Stock
will have five votes per share on all matters submitted to a vote of the
stockholders in the event that any person or group of persons acquires
beneficial ownership of 20% or more of the outstanding voting securities
of the Company. The Class B Common Stock is convertible into shares of
Class A Common Stock at any time. The classes of Common Stock are alike in
all other respects.

(8) Options and Warrants

1991 Plan

In September 1991, the Board of Directors authorized the establishment of
a stock option plan (the "1991 Plan"). The total number of shares of Class
B Common Stock subject to the Plan was 2,700,000. Options terminate upon
the earlier of the date of the expiration of the option or upon
termination of the employment relationship between the Company or a
subsidiary and the optionee for any reason other than death, disability or
retirement.

Under the 1991 plan, employees are entitled to exercise their options on
dates determined by the Compensation Committee of the Board of Directors.
Vesting provisions for options granted generally range from immediate
vesting to pro rata vesting over a three-year period. Options granted
under the 1991 Plan may, in the discretion of the Compensation Committee,
include the right to acquire a reload option. A reload option provides for
the automatic grant of a new option at the then-current market price in
exchange for each previously owned share tendered by an employee in a
Stock-for-Stock exercise.

Subsequent to January 1994 no further options, other than reload options,
may be granted under the 1991 Plan. All options outstanding under the 1991
Plan continue in full force and effect subject to their original terms. As
of December 31, 2000, there remained 235,032 options outstanding under the
1991 plan at exercise prices ranging from between $1.67 and $3.50 per
share.

1994 Plans

In January 1994, the Board of Directors authorized the establishment of
the 1994 Employee Stock Option Plan (the "1994 Plan"). The initial number
of shares of Class A Common Stock subject to the 1994 Plan was 1,000,000.
The terms of the 1994 Plan are similar to those of the 1991 Plan. Options
are granted with exercise prices that approximate fair market value at the
date of grant. In May 1996, July 1997, November 1998 and June 2000 the
Board of Directors approved amendments to the Company's 1994 Plan to
increase the number of shares of Class A Common Stock reserved for
issuance thereunder by 1,000,000, 1,000,000, 5,000,000 and 5,000,000,
respectively. Therefore, the

(Continued)

F-23

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

total number of shares of Class A Common Stock reserved for issuance under
the 1994 Plan is 13,000,000 shares. As of December 31, 2000, there were
approximately 3,800,000 shares available for grant under the 1994 Plan.

In January 1994, the Board of Directors authorized the establishment of
the Non-Employee Directors Stock Option Plan (the "Directors' Plan"). The
total number of shares of Class A Common Stock subject to the Directors'
Plan was initially 200,000. Pursuant to the Directors' Plan, each director
who was not an employee of the Company received an initial grant of
options to purchase 12,000 shares of Class A Common Stock at an exercise
price of $3.50 per share.

Any person subsequently elected as a director who was not an employee of
the Company received an initial grant of options to purchase 12,000 shares
of Class A Common Stock on the day he or she was elected a director. In
addition, on the day immediately following each of the dates on which an
incumbent director was reelected, he or she received an additional grant
of options to purchase 2,000 shares of Class A Common Stock.

The Stockholders of the Company have since, authorized certain changes to
the Directors' Plan. In February 1995, the annual option grant for
directors was increased from a total of 2,000 shares of Class A Common
Stock to 10,000 shares of Class A Common Stock. In July 1995, the Board
authorized an increase to the total number of shares subject to the
Directors' Plan from 200,000 shares to 500,000 shares. In November 1998,
the stockholders of the Company authorized an increase to the total number
of shares subject to the Directors' Plan from 500,000 shares to 1,000,000
shares. The stockholders also amended the Directors' Plan to provide that
options issued to non-employee directors under such plan vest on the day
following the grant. (Initial option grants under the Directors' Plan
vested one-third upon grant, and one-third on each of the first and second
anniversaries. Annual option grants vested 25% after each three-month
period following grant.)

Options under the Directors' Plan are exercisable for a period of ten
years from the date of grant. Options may not be exercised after the
option holder ceases to be a director of the Company, except that in the
event of death or disability of the option holder, the option may be
exercised for a period of one year after the date of death or disability,
and, in the event of retirement of the option holder, the option may be
exercised for a period of three months after the date of retirement.

In September 1996, the Board of Directors authorized the establishment of
the 1996 Performance Stock Option Plan ( the "1996 Plan"). The initial
number of shares of Class A Common Stock subject to the 1996 Plan was
800,000. The terms of the 1996 Plan are similar to those of the 1994 and
1991 Plans. Options are granted with exercise prices that approximate fair
market value at the date of grant.

The per share weighted-average fair value of stock options granted during
2000, 1999 and 1998 was $12.18, $8.28 and $1.97 on the dates of grant
using the Black Scholes option-pricing model with the following
weighted-average assumptions:

2000 1999 1998
--- --- ---

Expected Life (Years) 5 10 10
Interest Rate 6.0% 6.0% 6.0%
Volatility 123% 113% 105%
Dividend Yield 0% 0% 0%

(Continued)

F-24

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

The Company applies APB Opinion No. 25 in accounting for its Plans.
Compensation expense has been recognized in the financial statements for
Stock options granted to employees at exercise prices below the market
value of $318,609 in 2000, $0 in 1999 and $234,723 in 1998. Deferred
compensation for stock options granted to employees at exercise prices
below market value was approximately $1,600,000 as of December 31,
2000; and will be recognized over a period of three years.

Had the Company determined compensation cost based on the fair value at
the grant dates for its stock options under SFAS No. 123, the Company's
net loss would have been increased to the pro forma amounts indicated
below:

2000 1999 1998
------------ ------------ ------------

Net loss - as reported $(47,655,893) $(28,052,572) $(16,586,027)
Net loss - pro forma (64,029,399) (39,811,659) (22,305,606)
Net loss to Common stockholders - as reported (47,655,893) (28,065,811) (17,444,890)
Net loss to Common shareholders - pro forma (64,029,399) (38,824,898) (23,164,469)
Loss per Common share - as reported (1.03) (.73) (.55)
Loss per Common share - pro forma (1.39) (1.04) (.23)

(Continued)

F-25

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

Summary of Option Activity
A summary of option activity through December 31, 2000 follows:

Class A and B shares Weighted average
subject to option exercise price
----------------- --------------

Balance at January 1, 1991 $ --
Options granted 30,000 1.67
----------

Balance at December 31, 1991 30,000 1.67
Options granted 816,750 1.18
----------

Balance at December 31, 1992 846,750 1.20
Options granted 949,186 3.10
----------

Balance at December 31, 1993 1,795,936 2.20
Options granted 310,200 3.05
Options canceled (108,500) 3.38
----------

Balance at December 31, 1994 1,997,636 2.27
Options granted 777,850 2.22
Options canceled (349,205) 2.11
Options exercised (681,700) .64
----------

Balance at December 31, 1995 1,744,581 2.92
Options granted 1,342,075 2.65
Options canceled (503,879) 3.20
Options exercised (214,091) 1.97
----------

Balance at December 31, 1996 2,368,686 2.79
Options granted 707,914 1.02
Options canceled (676,741) 1.57
Options exercised (70,326) 1.90
----------

Balance at December 31, 1997 2,329,532 2.38
Options granted 5,756,893 2.47
Options canceled (707,384) 2.48
Options exercised (78,653) 1.94
----------

Balance at December 31, 1998 7,300,388 $ 2.40
Options granted 1,925,447 10.15
Options canceled (450,378) 3.51
Options exercised (964,000) 1.69
----------

Balance at December 31, 1999 7,811,456 $ 4.33
Options granted 3,444,037 13.58
Options canceled (903,488) 12.33
Options exercised (2,030,958) 2.51
----------

Balance at December 31, 2000 8,319,392 $7.90

(Continued)

F-26

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

At December 31, 2000, there were approximately 2,659,193 options exercisable at
prices ranging from $.49 to $37.50.

The following table summarizes information about stock options outstanding at
December 31, 2000:

Weighted
Weighted average
average remaining
Range of Number Number exercise contractual
exercise prices outstanding exercisable price life
- --------------- ----------- ----------- ----- ----

$.49 - 1.06 53,585 51,026 $ .90 6.7 years

1.07 - 1.69 1,381,884 670,896 1.56 6.8 years

1.70 - 2.31 62,490 40,681 1.74 7.3 years

2.32 - 2.97 7,934 3,345 2.56 6.4 years

2.98 - 3.50 256,066 103,033 3.49 7.4 years

3.51 - 3.81 1,884,100 1,186,341 3.66 7.2 years

3.82 - 7.06 1,253,268 259,673 5.32 8.5 years

7.06 - 15.75 2,783,697 332,198 12.89 8.6 years

15.76 - 37.50 636,368 12,000 19.70 9.5 years

1999 WaveXpress Stock Incentive Plan

In April 2000, WaveXpress authorized the establishment of a stock option plan
(the "1999 Plan"). The total number of shares of WaveXpress' Class A common
stock subject to the Plan is 2,500,000. Options terminate upon the earlier of
the date of expiration of the option or upon termination of the employment
relationship between WaveXpress and the optionee for any reason other than
death, disability or retirement.

Employees are entitled to exercise their options on dates determined by
WaveExpress' Compensation Committee of the Board of Directors. Vesting
provisions for options granted generally range from immediate vesting to pro
rata vesting over a three-year period.

A summary of option activity through December 31, 2000 follows:

CLASS A SHARES WEIGHTED AVERAGE
SUBJECT TO OPTION EXERCISE PRICE
----------------- ----------------
Balance at December 31, 1999 -- --
Options granted 2,761,600 .40
Options canceled 166,667 .40
Options exercised -- --
--------- -----
Balance at December 31, 2000 1,904,933 .40

The following table summarizes information about stock options outstanding at
December 31, 2000:

Range of Number Number Contractual
exercise prices outstanding exercisable life
--------------- ----------- ----------- -----------
.40-1.50 1,904,933 291,667 3-10 years

The Company did not include the value of these shares in the SFAS 123 pro
forma disclosure as the effect would be immaterial.

Warrants

In 1993 and 1994, the Company issued warrants to acquire a total of
151,600 shares of Class B Common Stock at $3.50 per share in conjunction
with sales of Class B Common Stock to individuals and institutions. All
warrants were exercisable for a period of five years from the date of
issuance and were subsequently canceled or exercised in 1998 and 1999.

In 1993 and 1994, the Company issued warrants to acquire a total of
376,253 shares of Class B Common Stock at $3.50 per share in conjunction
with the issuance of its 10% Convertible Notes which have since been
repaid and in 1994, the Company issued warrants to acquire a total of
46,799 shares of Class B Common Stock at $6.00 per share in conjunction
with the issuance of its 15% Notes, also which have since been repaid. All
warrants were exercisable for a period of five years from their dates of
issuance. These warrants were exercised or canceled in 1998 and 1999.

Under the terms of the Company's initial public offering, the underwriter
acquired warrants to purchase 360,000 Class A Common Stock at a price of
$6.50 per share for nominal consideration. These warrants were exercisable
for four years commencing in September 1995. These warrants were exercised
during 1999.

As a result of the successful placement of 350 shares of Series B
Preferred Stock, a consultant from Digital Media Group, Inc. was issued
warrants by the Company to purchase 15,000 Class A Common

(Continued)

F-27

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

shares at a price of $3.09 per share. These warrants are exercisable for
ten years commencing in March 1996, and are still outstanding.

Due to the successful placement of 150,000 shares of the Company's Series
C Convertible Stock, Wharton Capital Partners Ltd. and The Shemano Group,
Inc., two financial consulting firms, were issued warrants by the Company
to purchase 37,500 Class A Common Stock each at a price of $2.54 per
share. These warrants were exercised in 1999.

In connection with the acquisition of WIN, the Company issued a warrant
that allowed the holder the ability to purchase unregistered shares of the
Company's Class A Common Stock at a price of $1.25 per share at the
earlier of the conversion of a note or April 18, 1998 for a period of five
years. The number of shares able to be purchased under this warrant is
based on a formula of $170,000 divided by 80% of the fair market value of
the Class A Common Stock at the time of conversion. This warrant was
subsequently extended one year by issuing 100,000 additional warrants to
be exercised at prices ranging from 1.49 to 3.43. These warrants were
exercised during July 1999.

As a result of the successful placement of 80,000 shares of the Company's
Series D Preferred Stock, JNC Opportunity Fund, the acquirer of the
placement, received 80,000 warrants to purchase the Company's unregistered
Class A Common Stock, and financial consultants, primarily Wharton Capital
Partners, received a total of 40,000 warrants. The warrants were exercised
in 1999 at an exercise price of $1.62.

As a result of the successful placement of 112,500 shares of the Company's
Series F Preferred Stock, Combination Inc., the acquirer of the placement,
received 112,500 warrants to purchase the Company's unregistered Class A
Common Stock, and Wharton Capital Partners received 56,250 warrants. The
warrants had an exercise price of $1.26, and expire on October 9, 2002.
The warrants were exercised in 1998.

In connection with the private placement of approximately 800,000 shares
of the Company's Class A Common Stock, the Company issued 160,000 warrants
to purchase shares of the Company's unregistered Class A Common Stock at
an exercise price of $1.00. The warrants were exercised or expired during
1999.

In connection with a technology license agreement with Aladdin Knowledge
Systems, Ltd., the Company issued two warrants on July 18, 1997 to
purchase the Company's Class A Common Stock. The first warrant was
exercisable in 100,000 share lots, and provided the holder with the right
to acquire 1,216,136 shares of the Company's unregistered Class A Common
Stock at an exercise price of $1.70 per share. The first warrant had a
life of two years. The second warrant provided the holder with the right
to acquire 7% of the Company's Class A Common Stock on a fully diluted
basis for the average closing price for the 15 trading days prior to
exercise and had a three year life. During June of 1998, Aladdin exercised
a portion of the second warrant to purchase 1,000,000 shares of Common
Stock. On March 31, 1999 Aladdin exercised their entire first warrant for
1,216,136 Class A Common Stock. Associated with the second warrant,
Aladdin had the right to acquire shares approximating 3.45% of the
Company's Class A Common Stock. The remaining shares under the second
warrant were not exercised, and expired July 17, 2000.

In connection with a $2,000,000 convertible promissory note, warrants to
acquire 275,000 shares of Class A Common Stock were issued. The Company
incurred a non-cash charge to interest expense for approximately $666,000.
These warrants were subsequently exercised in January 2000.

(Continued)

F-28

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

Additional warrants were exercised during the year ended December 31, 2000
to purchase 44,692 shares of the Company's Class A Common Stock. These
warrants were exercised at prices ranging from between $1.10 and $5.50 per
share.

(Continued)

F-29

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

A summary of warrants outstanding at December 31, 2000, follows:

Range of
Class A and B shares exercise Expiration
subject to warrants prices Term
------------------- ------ ----

65,320 $1.83 - $3.09 5-10 years
20,000 $10.00 - $14.73 5 years
------
85,320
======

At December 31, 2000, warrants to acquire approximately 63,400 shares of
Class A and Class B Common Stock were exercisable.

(9) Licensing Agreements

(a) Licensed Patents

In February 1994, the Company entered into an Amended and Restated License
Agreement (the "Agreement") with Mr. Peter J. Sprague, the Chairman and
former Chief Executive Officer of the Company, and Mr. John Michener, then
a shareholder and officer of the Company, whereby the Company was granted
an exclusive license to make, have made, use, lease, sell or otherwise
perform services covered by certain licensed patents (the "Licensed
Patents") which are a fundamental part of the Company's product. The
Agreement amends and restates certain license agreements entered into by
the Company prior to February 1994.

The Agreement provides for royalty payments to be made to the licensors in
the aggregate amount of two percent of the total gross revenues derived by
the Company and any sublicensee of the Company from the exploitation of
the Licensed Patents, less any amounts paid, if any to (i) information and
database providers for information distributed to or through the Company
or its sublicensees, and to (ii) the Company's sublicensees for
manufacturing the product or performing the services covered by the
Licensed Patents. Royalty payments are payable quarterly and are to be
apportioned 75% to Mr. Sprague and 25% to Mr. Michener.

Payment of royalties is secured by a security interest in and to the
Licensed Patents. Mr. Sprague assigned all of his right, title, and
interest in the Licensed Patents to the Company.

The Company believes that the agreements as a whole provide it with
exclusive rights under the Wave Patents. There can be no assurance that
the Company will enjoy exclusive rights to the Licensed patents under
these agreements no payments have been made to date.

(b) Aladdin License Agreement

During the third quarter of 1997 the Company entered into a license
agreement with Aladdin Knowledge Systems, Ltd. ("Aladdin"), an Israeli
company, for technology and in-process research and development related to
Aladdin's proprietary persistent encryption system. Under the terms of the
Aladdin license agreement, the Company is prohibited from using any other
encryption technology for the first five years. This technology will be
incorporated into the Wave System to facilitate pay-per-view content
distribution.

(Continued)

F-30

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

The Company acquired the license for this technology in exchange for
$950,000 plus two warrants to purchase the Company's Class A Common Stock
valued at approximately $2.9 million (see note 8). The cost of this
license was expensed as research and development costs. Aladdin also is
provided a royalty payment of 5% to 9% of the Company's net content
revenues.

In connection with this agreement, Aladdin acquired an equity position in
the Company by purchasing 500,000 shares of the Company's Class A Common
Stock for $900,000, which approximated the fair market value of the shares
on the date of purchase (see note 7).

(10) License and Cross-License Agreements

On May 1, 1992, the Company entered into a Joint Technology Development
Agreement and License and Cross-License Agreement ("License and
Cross-License Agreement") with The Titan Corporation ("Titan") whereby
Titan granted to the Company license rights to the use of certain patents
which are co-owned or licensed by Titan. The Company granted to Titan the
exclusive right to make for, sell in, and lease in a "Retained Market," as
defined in the agreement, the subject matter described in any Company
patent. The Retained Market is defined generally as the market for
"Government Information," as defined in the agreement, used solely by a
government entity, and the market for products used to access such
information. The Company issued to Titan 674,976 shares of Class B Common
Stock in return for the license to Titan's patents. These shares were
valued at $1.67 per share (total $1,124,960), the estimated fair value of
the shares at the time of issuance (based on the price at which shares
were sold to third parties near the time of issuance), and were included
in research and development expense in the accompanying consolidated
statement of operations for the period from February 12, 1988 through
December 31, 2000.

The License and Cross-License Agreement provides for royalties to be paid
by the Company to Titan based upon the Company's "Net Revenues," as
defined in the agreement. Net Revenues are defined generally as gross
product revenues less amounts paid to information providers and data base
providers for information provided to the Company for use in its products
and services. Royalties are payable on a quarterly basis.

The License and Cross-License Agreement also provides for royalties to be
paid to the Company by Titan based upon Titan's "Allocable Net Revenues,"
as defined in the agreement. Allocable Net Revenues are generally defined
as that portion that a Company patent or information adds to Titan's gross
amounts invoiced to purchasers for all products or information services
making use of a Company patent or know-how and information. Royalties are
payable on a quarterly basis.

The License and Cross-License Agreement specifies certain events of
termination, some of which have already occurred but which have been
waived or extended by Titan.

A director of the Company, who resigned from the Board at the end of 1997,
is also the President, Chief Executive Officer, and a director of Titan.
Pursuant to the terms of a related stockholders agreement, Titan has the
right to designate a member of the Company's Board of Directors for as
long as Titan continues to own at least 50% of the shares originally
issued to Titan. As of December 31, 2000, no royalties have been earned by
Titan. On February 28, 1997, the Company and Titan executed an addendum to
the License Agreement whereby the Company received a sole license to
Titan's patent to develop and distribute products to the in-home consumer
microcomputers market segment. Under this addendum, Titan waived all
defaults previously incurred by Wave as well as extended the license
agreement to expire at the time the patents expire.

(Continued)

F-31

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

(11) Revenue Sharing Agreements With Partners

The Company has, and intends to continue to, enter into revenue sharing
arrangements with information providers, software developers, and hardware
and systems manufacturers, such as IBM discussed below. These revenue
sharing arrangements will be negotiated between each of the partners and
the Company. It is anticipated that revenue sharing arrangements will vary
according to the market in which the Wave system is adopted and from which
revenues are derived. Generally, a significant portion of the revenue
collected by the Company will be paid directly to the information provider
or software developer. Once these payments are made the remainder of
revenues will be shared between the Company and other partners. There can
be no assurance that the Company will be successful in entering into
definitive agreements with these parties, or that the terms of such
agreements will be favorable to the Company.

(12) Joint Ventures

(a) Global Wave, Ltd

In July of 1997, the Company entered into a joint venture with Internet
Technology Group, PLC ("ITG"), a United Kingdom Internet service provider.
The joint venture was initially owned 25% by the Company and 75% by ITG.
The Company contributed its technical expertise and ITG contributed
initial working capital and the commitment to fund all future working
capital requirements of the joint venture. The objective of the joint
venture company, Global Wave, Ltd., ("Global Wave") is to promote and
commercialize the Wave technology in certain European and Middle Eastern
markets. Pursuant to the joint venture agreement, the Company received a
license fee of $5 million in exchange for the joint venture's right to
market the Wave technology in European and Middle Eastern markets. The
license fee was paid by ITG as part of its commitment to fund the joint
venture. During the third quarter of 1997, the Company received $1.0
million from the joint venture representing partial payment of the license
fee, with the remaining payments to be made upon the Company's attaining
certain milestones related to the number of Wave Meters distributed. The
amount received was recorded as deferred license fee income in the third
quarter of 1997 as it was uncertain whether the Company had met the
contractual requirements required in order to have earned the first
payment. During the fourth quarter of 1997, the Company met these
requirements and began recognizing the license fee ratably over the
contractual period, and recorded the $1 million as a license fee income.
Also the Company accrued $490,000 in the fourth quarter of 1997 for
expenses related to the Company's obligation to assist the joint venture
in setting up the Wave system in the designated markets. In January 1998,
the joint venture agreement was modified to extend the milestone dates and
provide for the payment of an additional $750,000 of the $5 million
license fee to the Company. The payment of $750,000 was received in
January 1998. The Company also received the final payment of $3.25 million
in June 1998. This payment and the $750,000 received in January 1998 total
$4 million received in 1998. As part of the Agreement, after the final
license fee was paid, the companies issued a warrant to each other to
purchase approximately one million shares of each other's Common Stock.
The exercise price of the Wave warrants was $1.75 per share. The exercise
price of the ITG warrant was approximately .995 British pound per share.
On June 5, 1998, the final milestone for the last payment on the license
fee was attained and the Company became obligated to issue its warrant to
ITG pending approval by the shareholders of ITG for it to issue its
reciprocal warrant. On this date the net fair market value of the exchange
of warrants represented a net cost to the Company of approximately $1.1
million. The Company recorded this cost as ITG net warrant cost in the
Consolidated Statement of Operations.

On November 5, 1999 the Company exercised its warrant for 1,000,000 shares
in ITG at a total cost of $1,620,000. Also during 1999 ITG exercised its
1,000,000 warrants in the Company yielding total proceeds of $1,750,000.
As of December 31, 1999 Wave's equity investment in ITG was valued at
$4,480,500 with an unrealized investment gain of $2,860,500.

(Continued)

F-32

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

In February, 2000 ITG was acquired by Concentric Network Corporation. As a
result of this transaction, the Company received $2,162,457 in cash and
83,910 shares of Concentric Common Stock. In addition, certain assets of
ITG, namely the 1,000,000 shares of Wave Common Stock and ITG's interest
in Global Wave, were distributed to Redwave, Plc. ("Redwave")

In June, 2000, Wave increased its ownership percentage of Global Wave from
25% to 40%. As part of the new joint venture agreement, Wave's partner in
the venture, Redwave, agreed to contribute $7.5 million and 500,000 shares
of Wave Common Stock held by Redwave, in exchange for 600,000 shares of
Global Wave Class A Common Stock. Wave received 400,000 shares of Global
Wave Class B Common Stock in exchange for a technology license granted by
Wave to Global Wave. Prior to September 30, 2000, no value had been
assigned to these shares, as Wave had not provided any funding to Global
Wave.

On October 10, 2000, Wave entered into an agreement with Global Wave and
Redwave to subscribe for additional Class B shares of Global Wave. Under
the terms of the agreement, Wave subscribed for 40,000 additional "B"
shares of Global Wave at (pound)100 per share (approximately $142.80), the
consideration for which consisted of (pound)1.5M (approximately $2.14M) in
development costs incurred by Wave on behalf of Global Wave, (pound)1.4M
in cash ($2.0M), and (pound)1.1M (approximately $1.6M) in future
development services, for total consideration of (pound)4.0M
(approximately $5.7M). In addition, Redwave has agreed to subscribe for an
additional 60,000 Global Wave "A" shares, the consideration for which
will consist of the conversion of debt and cash totaling (pound)6.0M
((pound)5,966,615 in debt and (pound)33,385 in cash; approximately $8.6
million). The resulting ownership interest in the venture will remain 60%
for Redwave and 40% for Wave.

Also, in October, 2000, Wave and Redwave formed a joint venture holding
company, Wave European Technologies plc, ("WET") for their European
interests, including their respective 40% and 60% stakes in Global Wave.
Subsequent to the formation of WET, WET's name changed to Global Wave
Group, Plc., ("Global Wave Group")

As of December 31, 2000, Wave has contributed approximately $4.1M of its
committed investment in the form of development costs incurred and cash.
Pursuant to the equity method of accounting, and because Wave has
committed to provide funding to the venture, the Company has recognized
its equity share (40%) of Global Wave's net losses since inception in its
results for the year-ended December 31, 2000. Global Wave's accumulated
net losses since inception are approximately $8.5 million through
December 31, 2000. Accordingly, Wave has recorded its equity in the net
losses of $3.4 million for the year-ended December 31, 2000. Because Wave
had previously not provided any funding, and had not committed to provide
any funding to Global Wave, none of it's equity in the prior period
losses were recognized by Wave in its prior year financial statements.

(b) WaveXpress

In April 1999, the Company joined with Sarnoff Corporation to form a new
joint venture, WaveXpress. WaveXpress develops secure data broadcast
architecture, infrastructure and content services. This technology and
these services will allow content providers to send digital content to
properly equipped PC's by utilizing unused bandwidth in the Digital
Television (DTV) Spectrum. Consumers will be able to purchase this content
directly through a secure network connection, thus enabling a significant
new revenue stream for broadcasters. On October 15, 1999, Wave and Sarnoff
signed the Joint Venture Agreement which formally established WaveXpress.
Under this agreement, Sarnoff and its affiliates received a 40% equity
stake in WaveXpress. Wave received a 53% equity interest; and its
affiliates, who purchased founders stock in April 1999 for a nominal
amount, own the remaining 7% of the outstanding capital stock. The
affiliates of Wave include Peter and Steven Sprague, the Chairman and
Chief Executive Officer of Wave, respectively, certain members of the

(Continued)

F-33

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

Board of Directors of Wave and certain Wave employees. Wave has funded
WaveXpress through a series of convertible notes with attached warrants.
Generally, the notes are convertible into shares of Common Stock of
WaveXpress at a price of $1.50 per share. In addition, the notes carry
attached warrants that allow the company to purchase additional shares of
WaveXpress, generally at the conversion price of the notes. If converted,
on a fully diluted basis, which would include all stock, warrants and the
WaveXpress employee stock option pool, the Company's equity interest would
be approximately 72%. The notes also bear interest at the rate of 2% to 3%
above the Prime Rate of Chase Manhattan Bank. Through December 31, 2000,
Wave had provided approximately $16.8 million in funds, including
approximately $1.0 million in accrued interest. These amounts are
eliminated in consolidation.

Neither Sarnoff nor any of the other minority shareholders have provided
or are obligated to provide funding to WaveXpress. Accordingly, the
financial statements of WaveXpress have been included in the consolidated
financial statements of the Company as of December 31, 2000 and for the
period then ended. In addition, the Company has not recorded a minority
interest in WaveXpress in the consolidated financial statements and
therefore has reflected 100% of WaveXpress' balance sheet and operating
results in its consolidated financial statements. WaveXpress has incurred
net losses of $11.2 million and $1.9 for the years ended December 31, 2000
and 1999, respectively.

(13) Commitments and Contingencies

Litigation

The Company is party to legal proceedings generally incidental to its
business. Management believes that the outcome of such litigation will not
have a material adverse effect on the consolidated financial position or
results of operations of the Company.

(Continued)

F-34

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

Leases

Summarized below is a listing of properties leased by Wave Systems Corp.
pursuant to non-cancelable operating leases. Our principal research and
development activities are conducted at the Princeton and Cupertino
facilities.

Annual Lease Lease Expiration
Location Cost Date
-------- ---- ----

Lee, MA $ 146,267 Aug. 2002

Danvers, MA 57,915 Mar. 2001

New York, NY 144,000 May 2001

Princeton, NJ 520,152 Dec. 2002

Cupertino, CA 488,134 Oct. 2002

San Jose, CA 110,203 Dec. 2001

Nashville, TN 39,724 Sep. 2003

Paris, France 48,000 Monthly

New York, NY (1) 628,290 Apr. 2010
----------

Total $2,182,685
==========

(1) WaveXpress facility

The Company was obligated under a capital lease for a phone system in the
Lee, Massachusetts office. At December 31, 2000 gross amount of the
equipment and related accumulated amortization recorded under capital
lease was as follows:

2000 1999
-------- --------
Phone Equipment $111,291 $111,291
Less: Accumulated Amortization 111,291 90,819
-------- --------
Ending Balance $ -0- $ 20,472
======== ========

Amortization expense of assets held under capital lease is included with
depreciation expense.

(Continued)

F-35

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

Future minimum lease payments under noncancelable operating leases (with
initial or remaining lease terms in excess of one year) and future minimum
capital lease payments as of December 31, 2000 are as follows:

Year ending December 31, Capital Lease Operating Lease
------------------------ ------------- ---------------

2001 -- 1,968,988
2002 -- 1,638,691
2003 -- 608,862
2004 -- 589,536
2005 -- 589,536
Thereafter -- 2,554,656
---------- ----------
Total minimum lease payments -- $7,950,269
========== ==========

(Continued)

F-36

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

Rent expense for the years ended December 31, 2000, 1999, 1998 and for the
period from inception through December 31, 2000 amounted to approximately
$1,960,000, $957,000, $561,000 and $5,079,000, respectively.

(14) Income Taxes

The Company has net operating loss carryforwards for tax return purposes
of approximately $104.9 million which expire beginning in 2003 through
2020.

Pursuant to the Internal Revenue Code, Section 382 of 1986, annual
utilization of the Company's net operating loss carryforwards may be
limited if a cumulative change in ownership of more than 50% occurs within
a three year period. The Company has not determined whether there has been
such a cumulative change in ownership or the impact on the utilization of
the loss carryforwards if such change has occurred.

The tax effects of temporary differences that give rise to the deferred
tax asset at December 31, 2000 and 1999 are as follows:

2000 1999
------------ ------------
Deferred tax assets:
Net operating loss carryforwards $ 42,263,000 $ 32,239,000
Start-up costs -- 1,114,000
Accrued expenses 324,000 145,000
License rights 548,000 626,000
In-Process R&D 857,000 --
Goodwill 122,000 --
Other Intangibles 68,000 --
Reserves 142,000 --
Depreciation 246,000 --
------------ ------------

Total gross deferred tax assets 44,570,000 34,124,000

Deferred tax liability
Unrealized Gain -- (1,152,000)
Depreciation -- (44,000)
------------ ------------
Total gross deferred tax liability -- (1,196,000)
Less valuation allowance (44,570,000) (32,928,000)
------------ ------------

Net deferred tax asset $ -- $ --
============ ============

The valuation allowance increased by approximately $ 11.6 million and $8.8
million, during the years ended December 31, 2000 and 1999, respectively.

Management has concluded that it is more likely than not that the Company
will not have sufficient taxable income of an appropriate character within
the carryback and carryforward period permitted by current law to allow
for the utilization of certain of the deductible amounts generating the
deferred tax assets and, therefore, a valuation allowance of $44,570,000
and $32,928,000 has been established to reduce the deferred tax assets at
December 31, 2000 and 1999 respectively.

(Continued)

F-37

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

(15) Defined Contribution Plan

The Company adopted the Wave Systems Corp. 401(k) Savings and Investment
Plan, a defined contribution plan, to which substantially all employees
can contribute on January 1, 1995. Employees of the Company become
eligible immediately on employment. The Company has the option to make
discretionary matching contributions; no contributions were made in 2000,
1999 or 1998.

(16) Disclosures about the Fair Value of Financial Instruments

Cash and Cash Equivalents, Marketable Securities, Prepaid Expenses and
Other Receivables , Accounts Payable and Accrued Expenses, and Note
Payable

The carrying amounts of these instruments, other than marketable
securities and the note payable, approximate fair value because of their
short maturities. Marketable securities are valued based on the value of
the securities as traded on the Nasdaq Stock Exchange.

Fair value estimates are made at a specific point in time, based on
relevant market information and information about the financial
instrument. These estimates are subjective in nature and involve
uncertainties and matters of significant judgment and therefore cannot be
determined with precision. Changes in assumptions could significantly
affect the estimates.

(Continued)

F-38

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

(17) Segment Reporting

Effective December 31, 2000, the Company adopted SFAS No. 131 "Disclosures
about Segments of an Enterprise and Related Information." SFAS 131
supercedes previously issued segment reporting disclosure rules and
requires reporting of segment information that is consistent with the way
in which management operates the Company. Prior to December 31, 2000, SFAS
131 was not applicable because the impact of adopting SFAS 131 would not
have been material.

The Company's products include the Wave EMBASSY(R) Trusted Client Platform
and Services and WaveXpress Data Broadcasting Products and Services. These
products and services constitute the Company's reportable segments. Net
Losses for reportable segments exclude interest income, interest expense,
equity in losses of equity method investees and realized gains on
marketable securities. These items are not reported by segment since they
are excluded from the measurement of segment performance reviewed by the
Company's management.

The following sets forth reportable segment data:

For the years ended December 31,
2000 1999 1998
------------ ------------ ------------

Operating Revenues:
EMBASSY(R) Trusted Client Platform and Services $ 332,522 $ 187,515 $ 47,681
WaveXpress Data Broadcasting -- -- --
------------ ------------ ------------
Total Operating Revenues 332,522 187,515 $ 47,681
============ ============ ============

(Net Loss):
EMBASSY(R) Trusted Client Platform and Services (1) (39,712,441) (25,983,028) (16,532,185)
WaveXpress Data Broadcasting (10,183,134) (1,853,873) --
------------ ------------ ------------
Total Segments Net Loss (49,895,575) (27,836,901) (16,532,185)
============ ============ ============
Interest Income 5,103,716 617,306 231,820
Interest Expense -- (832,976) (285,662)
Equity in net losses of equity method investees (3,406,491) -- --
Gain on sale of marketable securities 542,457 -- --
------------ ------------ ------------
Net Loss (47,655,893) (28,052,571) (16,586,027)
============ ============ ============

Depreciation and Amortization Expense:
EMBASSY(R) Trusted Client Platform and Services (2) 2,228,078 758,223 487,155
WaveXpress Data Broadcasting 939,060 9,771 --
------------ ------------ ------------

Total Depreciation Expense 3,167,138 767,994 487,155
============ ============ ============

Capital Expenditures:
EMBASSY(R) Trusted Client Platform and Services 1,323,485 1,989,381 590,619
WaveXpress Data Broadcasting 4,275,815 1,867,258 --
------------ ------------ ------------
Total Capital Expenditures $ 5,599,300 $ 3,856,639 $ 590,619
============ ============ ============

Assets:
EMBASSY(R) Trusted Client Platform and Services 92,164,096 14,640,852 6,023,991
WaveXpress Data Broadcasting 5,920,365 1,891,031 --
------------ ------------ ------------
Total Assets $ 98,084,461 $ 16,531,883 $ 6,023,991
============ ============ ============

(1) Includes $2,176,000 in acquired in-process research and development for
the year-ended December 31, 2000 (See Note 12).

(2) Includes $573,544 in goodwill amortization for the year-ended December 31,
2000 (See note 12)

(Continued)

F-39

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation) - (Continued)

Notes to Consolidated Financial Statements

(18) Subsequent Events

On February 2, 2001, the Company entered into a stock purchase agreement
(the "Agreement") with BIZ Interactive Zone, Inc. ("BIZ") to acquire
3,600,000 shares of the Series B Preferred Stock of BIZ in exchange for
2,000,000 shares of the Company's Class A Common Stock. The Company's
investment in BIZ represents approximately 17.8% of the outstanding
capital stock of BIZ. Accordingly, the Company intends to account for this
investment using the Cost Method of accounting, as the investment
represents less than a 20% ownership interest. BIZ is a privately held
company.

In a related event, Litronic, Inc, ("Litronic"), a provider of
authentication and encryption security technology signed a term sheet to
merge with BIZ. Litronic trades on the NASDAQ National Stock Market. The
transaction is to be structured as a reverse triangular merger whereby
Litronic Stockholders will own approximately 47% and BIZ stockholders will
own 53% of the combined company.

As part of the Agreement, in the event of a merger with Litronic, the
Company shall own 13.78% of the outstanding shares, on a fully diluted
basis, of the combined company resulting from the merger.