SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

ý  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2004

 

OR

 

o  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 incorporation or organization)		(I.R.S. Employer 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)

 

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  ý  No  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).

 

Yes  o  No  ý

 

The number of shares outstanding of each of the issuer’s classes of common stock as of October 31, 2004: 70,692,827 shares of Class A Common Stock and 205,725 shares of Class B Common Stock.

 

 

PART I -                FINANCIAL INFORMATION

 

Item 1.    Financial Statements

 

WAVE SYSTEMS CORP. AND SUBSIDIARIES

(a development stage corporation)

Consolidated Balance Sheets

(Unaudited)

 

		As of
		September 30, 2004			December 31, 2003
Assets:
Current assets:
Cash and cash equivalents		$	1,666,407		$	8,818,305
Cash collected on behalf of charities		—			211,717
Marketable securities		3,124,339			6,325,310
Prepaid expenses and other receivables		301,283			205,472
Total current assets		5,092,029			15,560,804
Property and equipment, net		1,724,646			2,286,876
Other assets		298,161			312,750
Total Assets		7,114,836			18,160,430
Liabilities and Stockholders’ Equity:
Current liabilities:
Accounts payable and accrued expenses		2,951,507			2,836,524
Due to charities		—			243,197
Deferred revenue		125,403			74,222
Total current liabilities		3,076,910			3,153,943
Liability for warrants containing cash settlement provisions		358,467			991,851
Total Liabilities		3,435,377			4,145,794
Common stock, $.01 par value. Authorized 120,000,000 shares as Class A; 70,692,827 shares issued and outstanding in 2004 and 67,128,106 in 2003		706,928			671,281
Common stock, $.01 par value. Authorized 13,000,000 shares as Class B; 205,725 shares issued and outstanding in 2004 and 2003		2,057			2,057
Capital in excess of par value		265,244,309			262,387,155
Deficit accumulated during the development stage		(264,216,534		)	(252,686,326		)
Accumulated Other Comprehensive Income – unrealized gain on marketable securities		1,942,699			3,640,469
Total stockholders’ equity		3,679,459			14,014,636
Total Liabilities and Stockholders’ Equity		$	7,114,836		$	18,160,430

 

See accompanying notes to unaudited consolidated financial statements.

 

1

 

WAVE SYSTEMS CORP. AND SUBSIDIARIES

(a development stage corporation)

Consolidated Statements of Operation

(Unaudited)

 

		Three months ended						Nine Months ended						Period from February 12, 1988 (inception) through September 30, 2004
		September 30, 2004			September 30, 2003			September 30, 2004			September 30, 2003
Net Revenues:
Product		$	—		$	95		$	6,660		$	1,433		$	496,124
Services		—			40,563			—			65,344			806,640
Licensing and other		44,375			39,470			94,458			63,482			721,027
Total Net Revenues		44,375			80,128			101,118			130,259			2,023,791
Cost of sales:
Product		—			60			4,647			2,863			288,572
Services		—			10,781			—			15,748			372,654
Licensing and other		35,041			20,033			60,620			21,437			235,618
Total Cost of Sales		35,041			30,874			65,267			40,048			896,844
Gross margin		9,334			49,254			35,851			90,211			1,126,947
Operating Expenses:
Selling, general, and administrative		2,887,805			2,831,799			9,695,238			9,535,085			150,053,879
Research and development		1,724,490			1,610,066			5,128,596			5,839,123			96,475,993
Write-off of intangibles and other impaired assets		—			—			301,366			—			3,634,314
Inventory provision		—			1,114,442			—			1,114,442			1,114,442
Restructuring costs and other special charges		—			—			—			—			726,280
Amortization of goodwill		—			—			—			—			2,294,176
Write-off of goodwill		—			—			—			—			3,054,456
In-process research and development expense		—			—			—			—			2,176,000
Acquisition costs		—			—			—			—			1,494,000
Aladdin license expense		—			—			—			—			3,889,000
Total Operating Expenses		4,612,295			5,556,307			15,125,200			16,488,650			264,912,540
Other income (Expense):
Interest income		5,198			9,894			18,692			66,579			10,284,815
Interest expense		—			—			—			—			(1,695,461		)
Equity in losses of GlobalWave		—			—			—			—			(5,738,650		)
Loss on other than temporary decline in marketable equity securities		—			—			—			—			(13,249,781		)
Gain (loss) on sale of marketable securities		514,407			—			2,907,065			(5,103		)	3,684,281
Liquidated damages		—			—			—			—			(155,716		)
Unrealized gain on changes in value of warrant liability		282,839			—			633,384			—			896,481
License fee		—			—			—			—			5,000,000
License warrant cost		—			—			—			—			(1,100,000		)
Gain on termination of development contract		—			—			—			—			1,818,000
Recovery on officer note receivable		—			—			—			999,518			—
Other income (expense)		—			—			—			52,370			(174,910		)
Total Other Income (Expense)		802,444			9,894			3,559,141			1,113,364			(430,941		)
Net loss		(3,800,517		)	(5,497,159		)	(11,530,208		)	(15,285,075		)	(264,216,534		)
Accrued dividends on preferred stock		—			2,816,596			—			5,696,218			10,048,115
Net loss to common stockholders		(3,800,517		)	$	(8,313,755	)	(11,530,208		)	$	(20,981,293	)	$	(274,264,649	)
Loss per common share		$	(0.05	)	$	(0.15	)	$	(0.17	)	$	(0.40	)	$	(11.19	)
Weighted average number of common shares outstanding during the period		69,632,567			54,030,247			68,116,582			52,748,026			24,518,916

 

See accompanying notes to unaudited consolidated financial statements.

 

2

 

WAVE SYSTEMS CORP. AND SUBSIDIARIES

(a development stage corporation)

Consolidated Statements of Cash Flows

(Unaudited)

 

		Nine Months ended						Period from February 12, 1988 (date of inception) Through September 30, 2004
		September 30, 2004			September 30, 2003
Cash flows from operating activities:
Net loss		$	(11,530,208	)	$	(15,285,075	)	$	(264,216,534	)
Adjustments to reconcile net loss to net cash used in operating activities:
Write-off of goodwill		—			—			3,054,456
Goodwill amortization		—			—			2,294,176
Depreciation and amortization		654,908			899,365			11,528,074
Reserve for note from affiliate		—			—			1,672,934
Recovery on officer note receivable		—			(999,518		)	—
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) loss on marketable securities		(2,907,065		)	5,103			(3,684,281		)
Net losses realized on GlobalWave investment		—			—			5,738,650
Common stock issued for services rendered and additional interest on borrowings		—			—			3,600,199
Warrants issued as compensation for services		80,609			43,176			3,018,880
Issuance of warrants to Aladdin		—			—			2,939,000
Accrued interest on note payable		—			—			121,219
In-process research and development		—			—			2,176,000
Write-off of impaired assets		301,366			—			3,634,314
Loss on other than temporary decline in marketable equity securities		—			—			13,249,781
Gain on termination of development contract with SSP Solutions, Inc.		—			—			(1,818,000		)
Unrealized gain on decrease in value of warrant liability		(633,384		)	—			(896,481		)
Preferred stock issued for services rendered		—			—			265,600
Compensation associated with issuance of stock options		—			35,284			2,019,263
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 in deferred revenue		51,181			86,333			125,403
Increase in accrued interest on note receivable		—			142,540			—
Decrease in inventories		—			1,111,443			—
(Increase) decrease in prepaid expenses and other receivables		(95,813		)	174,853			(270,964		)
(Increase) decrease in other assets		14,589			37,327			(313,076		)
Increase (decrease) in accounts payable and accrued expenses		114,985			(566,090		)	3,340,606
Decrease in amounts due to charities		(243,197		)	(263,156		)	—
Decrease in cash restricted on behalf of charities		211,717			235,553			—
Net cash used in operating activities		$	(13,980,312	)	$	(14,342,862	)	$	(210,046,658	)

 

3

 

		Nine Months ended						Period from February 12, 1988 (date of inception) Through September 30, 2004
		September 30, 2004			September 30, 2003
Cash flows from investing activities:
Acquisition of property and equipment		$	(394,044	)	$	(576,470	)	$	(12,822,667	)
Investment in GlobalWave joint venture		—			—			(5,701,250		)
Cash received in connection with GlobalWave acquisition		—			—			1,380,464
Purchase of intangible assets		—			—			(2,500,000		)
Short-term loans to affiliate		—			—			(1,672,934		)
Organizational costs		—			—			(14,966		)
Proceeds from sale of marketable securities		4,410,266			52,422			7,003,657
Exercise of warrants to acquire securities available-for-sale		—			—			(1,620,000		)
Net cash provided by (used in) investing activities		4,016,222			(524,048		)	(15,947,696		)
Cash flows from financing activities:
Net proceeds from issuance of common stock		2,812,192			4,935,377			207,347,898
Net proceeds from issuance of preferred stock and warrants		—			4,780,540			16,988,570
Note receivable from officer		—			1,135,321			—
Payment of dividends on preferred stock		—			(194,456		)	(212,517		)
Proceeds from notes payable and warrants to stockholders		—			—			4,083,972
Repayments of notes payable to stockholders		—			—			(1,069,972		)
Proceeds from notes payable and warrants		—			—			1,284,250
Repayments of note payable		—			—			(255,000		)
Redemption of preferred stock		—			—			(506,440		)
Net cash provided by financing activities		2,812,192			10,656,782			227,660,761
Net increase (decrease) in cash and cash equivalents		(7,151,898		)	(4,210,128		)	1,666,407
Cash and cash equivalents at beginning of period		8,818,305			10,221,124			—
Cash and cash equivalents at end of period		$	1,666,407		$	6,010,996		$	1,666,407

 

See accompanying notes to unaudited consolidated financial statements.

 

4

 

WAVE SYSTEMS CORP. AND SUBSIDIARIES

(a development stage corporation)

 

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)

(Unaudited)

 

		Class A Common Stock					Class B Common Stock					Capital in excess of par value			Deficit accumulated during the development stage			Accumulated other comprehensive income (loss)					Total
		Shares		Amount			Shares		Amount
Balance at December 31, 2003		67,128,106		$	671,281		205,725		$	2,057		$	262,387,155		$	(252,686,326	)			$	3,640,469		$	14,014,636
Net loss		—		—			—		—			—			(11,530,208		)	—		—			(11,530,208		)
Unrealized gain on marketable securities:
Unrealized holding gains during the period		—		—			—		—			—			—			1,209,295		—
Less: reclassification adjustment for gains included in net income																		(2,907,065	)	(1,697,770		)	(1,697,770		)
Comprehensive income (loss)		—		—			—		—			—			—			—		—			(13,227,978		)
Issuance of Class A Common Stock at $0.85 per share, net of issuance costs of $222,101		3,529,412		35,294			—		—			2,742,603			—			—		—			2,777,897
Issuance of warrants to purchase Class A Common Stock for services		—		—			—		—			80,609			—			—		—			80,609
Issuance of Class A Common Stock upon exercise of warrants and employee stock options		35,309		353			—		—			33,942			—			—		—			34,295
Balance at September 30, 2004		70,692,827		$	706,928		205,725		$	2,057		$	265,244,309		$	(264,216,534	)			$	1,942,699		$	3,679,459

 

See accompanying notes to unaudited consolidated financial statements.

 

5

 

WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Notes to Unaudited Consolidated Financial Statements

 

September 30, 2004 and 2003

 

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the financial position of Wave Systems Corp. as of September 30, 2004 and December 31, 2003, and the results of its operations and cash flows for the periods ended September 30, 2004 and 2003.  Such financial statements have been prepared in accordance with the applicable regulations of the Securities and Exchange Commission (the “Commission”).

 

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted.  It is suggested that these consolidated financial statements be read in conjunction with Wave’s audited financial statements and notes thereto for the year ended December 31, 2003, included in its Form 10-K filed on March 24, 2004.  The results of operations for the quarter ended September 30, 2004, are not necessarily indicative of the operating results for the full year.

 

The consolidated financial statements of Wave include the financial statements of Wave Systems Corp.; Wave Systems Holdings, Inc., a wholly owned subsidiary and Wavexpress, Inc., a joint venture between Wave and Sarnoff Corporation.  All significant intercompany transactions have been eliminated.  The financial statements of Wave have been presented in the development stage format as prescribed by Statement of Financial Accounting Standard No. 7.  Management has determined that Wave meets the criteria of a development stage enterprise as prescribed in Statement of Financial Accounting Standard No. 7 because it has devoted substantially all of its efforts since inception toward research and development activities and establishing a new business and, although planned principal operations have commenced, there has been no significant revenue from those operations.

 

1.     Liquidity

 

The accompanying consolidated financial statements have been prepared assuming that Wave will continue as a going concern.  Wave has incurred substantial operating losses since its inception, and as of September 30, 2004, has an accumulated deficit of approximately $264.2 million.  We also expect Wave will incur an operating loss for the calendar year of 2004.  As of September 30, 2004, we had working capital of approximately $2.0 million.

 

Considering our current cash balance and marketable equity securities, we project that we have enough liquid assets to continue operating through December 31, 2004.  We will need approximately $13,000,000 of additional cash to fund operating expenses and capital expenditures for the twelve-month period ending September 30, 2005.

 

Wave has begun market introduction of its security and broadband media distribution software products and has signed its initial distribution contracts for these applications.  However, due to the early stage nature of this market, Wave is unable to predict with a high level of certainty whether enough revenue will be generated over the twelve-month period ending September 30, 2005, to fund its cash flow requirements, referred to above.

 

It is likely that we will be required to raise additional capital through either equity or debt financings, in order to adequately fund our capital requirements.  To this end, on April 15, 2004, we filed a shelf registration statement for up to $25,000,000 of common stock, which was declared effective by the Securities and Exchange Commission on May 10, 2004.  We received approximately $2.8 million net of underwriter and other fees, through the sale of approximately 3.5 million shares of our Class A Common Stock on August 2, 2004 that are covered by the shelf registration statement.  In addition, a total of approximately 3.5 million shares were offered in connection with this sale and issuance of shares, in the form of an additional investment right with an exercise price of $1.00 per share and warrants for approximately 4.4 million shares at exercise prices ranging from $1.15 to $1.30 per share.  The additional investment right expired on November 2, 2004. The warrants are exercisable during the period January 30,

 

6

 

2004 through January 30, 2005, and if exercised, may yield approximately $5.0 million in proceeds, net of offering expenses.  We intend to utilize this shelf registration to issue and sell additional shares of our Class A Common Stock to the extent necessary to fund our operations for the foreseeable future.   Presently, after subtracting the potential proceeds from the offering described above, there remains $16.8 million in available proceeds, less offering expenses, from this shelf registration.

 

If Wave is not successful in raising the needed capital referred to above, or is not successful executing its business plan, it could be forced to cease operations or merge with another company.  No assurance can be provided that any of these initiatives will be successful.  Due to our current cash position, our capital needs over the next year and beyond, the fact that we have not at this time secured enough financing to fund our operations through September 30, 2005, and the uncertainty as to whether we will achieve our sales forecast for our products and services, substantial doubt exists with respect to our ability to continue as a going concern.

 

2.     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.  Diluted net loss per share is also computed using the weighted average number of common shares and excludes dilutive potential common shares outstanding, as their effect is anti-dilutive.  Dilutive potential common shares consist primarily of employee stock options, stock warrants and convertible preferred stock.  Diluted net loss per share is equal to basic net loss per share and is therefore not presented separately in the financial statements.  There were no potential common shares that would have been included in diluted loss per share, for the quarter ended September 30, 2004.  The number of potential common shares that would have been included in diluted loss per share, had their effect not been anti-dilutive for the nine-month period ended September 30, 2004 were 320,000 shares, versus  9,706,000 and 4,871,000 for the quarter and nine-month period ended September 30, 2003, respectively.  Employee stock options and other stock warrants to purchase a weighted average of approximately 16,822,000 and 13,045,000 shares were outstanding for the quarter and nine-month periods ended September 30, 2004, respectively versus a weighted average of approximately 9,989,000 and 11,423,000 shares for the quarter and nine-month periods ended September 30, 2003, respectively, but would not have been included in the computation of diluted loss per share because their exercise price was greater than the average share price of the common shares and, therefore, the effect would have been anti-dilutive.

 

3.     Investments in Marketable Securities

 

On February 2, 2001, Wave issued 2,000,000 shares of its Class A Common Stock, at a price of $7.16 per share, for an aggregate purchase price of $14,312,800 to acquire 3,600,000 shares of the Series B Preferred Stock of BIZ Interactive Zone, Inc., then a privately held company, in a private placement exempt from registration under Section 4(2) of the Securities Act of 1933, as amended.  Wave’s investment in BIZ represented approximately 17.8% of the outstanding capital stock of BIZ.  Accordingly, the investment had been accounted for under the cost method of accounting, because the investment was less than 20% of the outstanding capital stock of BIZ and because Wave could not exercise significant influence over BIZ.  On August 24, 2001, SSP Solutions, Inc. was formed through a merger with Litronic, Inc., a publicly traded company that provided authentication and encryption security technology.  As a result of the merger, Wave was issued 3,083,083 shares (14.95%) of the common stock of SSP in exchange for the BIZ shares it held.

 

During 2002, SSP issued Wave an additional 1,800,000 shares of common stock in connection with the cancellation of a development agreement that was entered into in October 2000.  The basis of the shares acquired in 2002 of $1,818,000 was recorded as a gain from termination of the development contract.

 

In August 2004, SSP merged with Saflink Corporation.  Pursuant to the merger agreement between SSP and Saflink, holders of SSP common stock were issued 0.6 shares of Saflink common stock for every share of SSP common stock held.  At the time of the merger, Wave held 2,043,283 shares of SSP, which were surrendered in exchange for 1,225,970 shares of Saflink, in accordance with the 0.6 ratio.

 

7

 

As detailed in the table below, Wave’s investments in marketable securities, which were classified as available-for-sale securities, consisted of 1,201,670 shares of Saflink valued at $3,124,339, as of September 30, 2004 and 4,550,583 shares of SSP valued at $6,325,310, as of December 31, 2003.

 

		Shares		Adjusted cost basis			Unrealized gain			Carrying value			Value per Share
Balance of investment in SSP Common Stock as of December 31, 2003		4,550,583		$	2,684,841		$	3,640,469		$	6,325,310		$	1.39
Sales of SSP common stock		(2,507,300	)	(1,479,307		)	—			(1,479,307		)	(0.59		)
Conversion of shares to Saflink Corp.		(817,313	)	—			—			—			0.39
Sales of Saflink Corp. common stock		(24,300	)	(23,894		)				(23,894		)	(0.98		)
Other comprehensive income - change in accumulated unrealized gain (see below)		—		—			(1,697,770		)	(1,697,770		)	—
Balance as of September 30, 2004		1,201,670		$	1,181,640		$	1,942,699		$	3,124,339		$	2.60

 

During the nine months ended September 30, 2004, Wave sold 2,507,300 shares of SSP, in a series of separate sales, at an average selling price of $1.73 per share, and 24,300 shares of Saflink at an average selling price of $2.68 per share, realizing an aggregate gain from the sales of $2,907,065.  For the nine months ended September 30, 2003, Wave sold 97,500 shares of SSP at an average selling price of $0.54 per share, realizing an aggregate loss from the sales of $5,103.  Wave uses the specific identification method to determine cost in computing realized gains or losses.

 

Wave recorded unrealized holding gains on marketable equity securities included in other comprehensive income, as follows, for the nine months ended September 30:

 

		2004			2003
Unrealized holding gains		$	1,209,295		$	2,483,400
Reclassification adjustment for realized (gains) losses on securities sold, included in net income		(2,907,065		)	5,103
Net change in accumulated unrealized gain		$	(1,697,770	)	$	2,488,503

 

4.     Wavexpress

 

In April 1999, Wave joined with Sarnoff Corporation to form Wavexpress.  Wavexpress develops secure data broadcast architecture, infrastructure and content services.  On October 15, 1999, Wave and Sarnoff signed a 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, owned the remaining 7% of the outstanding capital stock.  The affiliates of Wave include Peter Sprague, the former Chairman of Wave and Steven Sprague, the Chief Executive Officer of Wave, certain members of the Board of Directors of Wave and certain Wave employees.

 

Wave has funded Wavexpress through a series of convertible notes, some with attached warrants.  The notes bear interest at the rate of 1% to 3% above the Prime Rate of Chase Manhattan Bank.  Generally, the notes are convertible into shares of common stock of Wavexpress at varying prices per share.    Through September 30, 2004, Wave had provided approximately $42.4 million in funds to Wavexpress, including approximately $7.1 million in accrued interest.  This amount includes approximately $9.9 million that automatically converted into 1,826,570 additional shares of Wavexpress at an average conversion price of $5.41 per share.  These amounts are eliminated in consolidation.

 

As of September 30, 2004, Wave owned 69.0% of Wavexpress while Sarnoff owned 25.6%.  (If Wave were to convert all of its convertible notes outstanding, Wave, Wavexpress and the other shareholders referred to above would own approximately 95%, 4% and 1%, respectively.)  None of the 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 Wave for all periods presented herein.  In addition, Wave 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’ net losses included in Wave’s consolidated financial statements were approximately $0.9 million for both quarters ended September 30,

 

8

 

2004 and September 30, 2003, and $2.8 versus $2.9 million for the nine-month periods ended September 30, 2004 and 2003, respectively.

 

5.     Employee Stock Options

 

Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148 “Accounting for Stock-Based Compensation Transition and Disclosure – an amendment to FASB Statement No. 123,” allows companies to recognize expense for the fair value of stock-based awards or to continue to apply the provisions of Accounting Principles Board (“APB”) Opinion No. 25 “Accounting for Stock Issued to Employees,” and disclose the effects of SFAS No. 123 as if the fair-value-based method defined in SFAS No. 123 had been applied.  Under APB Opinion No. 25, compensation expense is recognized only if on the measurement date the fair value of the underlying stock exceeds the exercise price.  Wave has elected to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123 and No. 148.

 

The following table shows Wave’s pro forma net loss and loss per share if the company had accounted for stock options under SFAS No. 123 for the periods presented:

 

		Three Months ended						Nine Months ended
		September 30, 2004			September 30, 2003			September 30, 2004			September 30, 2003
Net loss to common shareholders – as reported		$	(3,800,517	)	$	(8,313,755	)	$	(11,530,208	)	$	(20,981,293	)
Net loss to common shareholders – pro forma		$	(4,504,061	)	$	(9,167,112	)	$	(13,667,298	)	$	(23,082,753	)
Loss per common share – as reported		(0.05		)	(0.15		)	(0.17		)	(0.40		)
Loss per common share – pro forma		$	(0.06	)	$	(0.17	)	$	(0.20	)	$	(0.44	)

 

6.     Warrants Containing Cash Settlement Provisions

 

Wave follows the FASB’s Emerging Issues Task Force pronouncement No. 00-19 (“EITF 00-19”) to account for derivative financial instruments indexed to, and settled in our own stock.  These would include financial instruments such as options or warrants to purchase Wave stock, but does not include employee stock options.  EITF 00-19 requires that freestanding financial instruments of this nature be classified as an asset or liability at fair value, in the event that the contract underlying any such financial instruments includes a net cash settlement provision.  In addition, EITF 00-19 requires any such asset or liability to be marked to market at the end of each period, with any resulting difference in fair value to be recorded as income or loss, through the company’s statement of operations, depending upon whether the difference results in a gain or loss.

 

On November 18, 2003, Wave granted warrants to purchase 931,309 shares of Wave common stock at an exercise price of $2.62 per share, in connection with a private placement of common stock with a group of accredited investors.  The warrants have a three-year term.  The contract underlying the warrants includes a provision that would require Wave to pay liquidated damages in cash to the warrant holders if the warrants are “in the money” and the registration statement underlying such shares ceases to remain continuously effective. Because of this provision, the contract is considered to contain a net cash settlement provision as defined in EITF 00-19.  Although the registration statement was declared effective by the Securities Exchange Commission on February 12, 2004, the net cash settlement provision still applies because of the stipulation that it must remain continuously effective and there are circumstances that could potentially cause the registration statement to cease to remain effective.  Accordingly, Wave recorded a liability in its balance sheet that was valued at approximately $358,000 as of September 30, 2004, and $992,000 as of December 31, 2003.  These values were arrived at utilizing the Black-Scholes option pricing model with the following assumptions:

 

		As of September 30, 2004		As of December 31, 2003
Expected life remaining (years)		2.17		3
Interest rate		2.7	%	3.25	%
Volatility		127	%	121	%
Dividend yield		0	%	0	%

 

9

 

The decrease in fair value of the liability associated with the warrants of approximately $633,000 was recorded as an unrealized gain in Wave’s statement of operations in the nine months ended September 30, 2004, in accordance with EITF 00-19.

 

7.     Contingencies

 

Securities and Exchange Commission Investigation

 

On December 17, 2003, Wave received an Order by the Securities and Exchange Commission (the “Commission”) regarding a formal investigation.  The focus of this investigation is on certain public statements made by Wave during and around August 2003, as well as certain trading in Wave’s securities during such time.  The Commission has not concluded that there has been any wrongdoing and Wave is cooperating fully with the Commission on this matter.  Wave cannot predict the potential effect on Wave as a result of this investigation at this time.

 

Purported Class Actions

 

Several (9 known) similar purported class action complaints have been filed between January 23, 2004, and February 23, 2004, most in the United States District Court for the District of Massachusetts, seven (7) of which name Wave, its Chief Executive Officer, its Chief Financial Officer and two (2) of which also name Wave’s Chairman of the Board, as defendants.

 

The purported class action complaints have been filed by alleged purchasers of Wave’s Class A Common Stock during the purported class period July 31, 2003, through February 2, 2004.  The plaintiffs have since filed consolidated amended complaints.  The complaints claim that Wave and the named individuals violated the federal securities laws by publicly disseminating materially false and misleading statements regarding Wave, relating to Intel and IBM agreements, resulting in the artificial inflation of Wave’s Class A Common Stock price during the purported class periods.  The complaints do not specify the amount of alleged damages plaintiffs seek to recover.

 

Wave intends to defend the actions vigorously.  At this time, Wave is unable to predict the outcome of these actions.

 

Derivative Actions

 

Wave has learned of three (3) other complaints filed in the United States District Court for the District of Massachusetts.  The plaintiffs have since filed consolidated amended complaints.  Wave believes that the complaints name all of its directors as defendants and allege claims for breach of fiduciary duties and other claims.  The allegations are very similar to the allegations made in the purported securities class actions because the allegations concern the very same alleged statements alleged in the purported class actions.  Wave is also named as a nominal defendant, although the actions are derivative in nature and purportedly asserted on behalf of Wave.  Wave is in the process of evaluating these claims.

 

Wave intends to defend the actions vigorously.  At this time, Wave is unable to predict the outcome of these actions.

 

8.     Impairment of Developed Software

 

In the quarter ended June 30, 2004, Wave took a charge of approximately $301,000 to write off developed software that had been capitalized.  The software that was written off was developed for a distribution agreement that was entered into with National Semiconductor Corp. (“NSC”) whereby NSC was to distribute it with their trusted platform module chip.  The write-off was the result of the termination of the agreement, and because the version of the software that was written off has been discontinued and superseded by a new version.  Consequently, the value of the software became impaired because it had no alternative uses.  Wave continues to maintain a license agreement with NSC, whereby Wave is paid royalties based on Wave Intellectual Property (“IP”) that is included in NSC’s chip design.

 

10

 

9.     Segment Reporting

 

Wave’s products include the Wave EMBASSY^® digital security products and services and Wavexpress broadband media distribution products and services.  These products and services constitute Wave’s reportable segments.  Net losses for reportable segments exclude interest, realized gains on marketable securities, recovery on note receivable, unrealized gain on decrease in value of warrant liability and other income.  These items are not reported by segment since they are excluded from the measurement of segment performance reviewed by Wave’s management.

 

The following sets forth reportable segment data (unaudited):

 

		Three months ended September 30,						Nine months ended September 30,
		2004			2003			2004			2003
Operating Revenues:
EMBASSY® digital security products and services		$	36,313		$	48,158		$	66,063		$	84,944
Wavexpress broadband media distribution products and services		8,062			31,970			35,055			45,315
Total Operating Revenues		44,375			80,128			101,118			130,259
Net Loss:
EMBASSY® digital security products and services		(3,676,120		)	(4,609,310		)	(12,287,250		)	(13,473,600		)
Wavexpress broadband media distribution		(926,841		)	(897,743		)	(2,802,099		)	(2,924,839		)
Total Segments Net Loss		(4,602,961		)	(5,507,053		)	(15,089,349		)	(16,398,439		)
Interest income		5,198			9,894			18,692			66,579
Gain (loss) on sale of marketable securities		514,407			—			2,907,065			(5,103		)
Recovery of note receivable		—			—			—			999,518
Unrealized gain on change in value of warrant liability		282,839			—			633,384			—
Other income		—			—			—			52,370
Net Loss		$	(3,800,517	)	$	(5,497,159	)	$	(11,530,208	)	$	(15,285,075	)
Depreciation and Amortization Expense:
EMBASSY® digital security products and services		184,684			215,912			532,184			644,909
Wavexpress broadband media distribution		26,330			64,176			122,724			254,456
Total Depreciation and Amortization Expense		$	211,014		$	280,088		$	654,908		$	899,365
Capital Expenditures:
EMBASSY® digital security products and services		11,805			116,104			271,348			536,652
Wavexpress broadband media distribution		6,559			16,119			122,696			39,818
Total Capital Expenditures		$	18,364		$	132,223		$	394,044		$	576,470

 

		As of
		September 30, 2004			December 31, 2003
Assets:
EMBASSY® digital security products and services		$	6,672,864		$	17,726,026
Wavexpress broadband media distribution		441,972			434,404
Total Assets		$	7,114,836		$	18,160,430

 

11

 

10.  Issuance of Common Stock

 

On July 30, 2004, Wave entered into a securities purchase agreement, pursuant to which Wave sold and issued 3,529,412 shares of Class A Common Stock, par value $.01 per share for an aggregate purchase price of $3,000,000.  The shares of Class A Common Stock were priced at $0.85.  Wave realized net proceeds of approximately $2.8 million after deducting placement agent and other fees associated with the issuance of these securities. These shares were drawn-down off of a shelf registration statement, which was filed by Wave on April 15, 2004, and declared effective by the Securities and Exchange Commission on May 10, 2004.  Wave also granted the purchaser a 90-day additional investment right and two series of warrants.

 

The additional investment right granted in this transaction allowed the purchaser to purchase up to 3,529,412 additional shares of Class A Common Stock at a price of $1.00 per share, and expired on November 2, 2004.  These shares would have been drawn-down off of the shelf registration statement, had the investment right been exercised.

 

The warrants granted in this transaction are made up of two different series.  The Series A warrants are exercisable for up to 3,529,412 shares of Class A Common Stock at an exercise price of $1.15 per share.  The Series A warrants are exercisable from January 30, 2005, until July 30, 2005.  The Series B warrants are exercisable for up to 882,353 shares of Class A Common Stock at an exercise price of $1.30 per share.  The Series B warrants are exercisable from July 30, 2005, until January 30, 2006.  The shares of Class A Common Stock issuable upon exercise of the Series A warrants and Series B warrants are also to be drawn-down off of the shelf registration statement, if the warrants are exercised.  Under the terms of the offering, in no event shall the Purchaser become the beneficial owner of more than 9.99% of the number of shares of Class A Common Stock outstanding immediately after giving effect to such issuance.  If exercised in their entirety, the warrants would generate an additional estimated $5.0 million in net proceeds to Wave.

 

Corpfin Inc. (the “Placement Agent”) entered into a placement agency agreement with Wave in which they have agreed to act as placement agent in connection with the offering.  Wave has agreed to pay the Placement Agent a fee equal to 4.0% of the actual gross proceeds from the sale of the shares and exercise of the investment rights and warrants referred to above.

 

CERTAIN FORWARD–LOOKING INFORMATION

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These statements include, but are not limited to, statements regarding contingencies, future prospects, liquidity and capital expenditures herein under “Part I - Financial Information—Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth below and detailed in our other filings with the Commission during the past 12 months.

 

Item 2.          Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

Our Business

 

Wave Systems Corp., a development stage company, develops, produces and markets products for hardware-based digital security, including security applications and services that are complementary to and compliant with the specifications of the Trusted Computing Group (“TCG”).  TCG is an industry standards body, comprised of computer and device manufacturers, software vendors and others whose purpose is to develop, define and promote open industry standard specifications for embedded hardware-enabled computing products, including security technologies across multiple platforms, peripherals and devices. The current TCG specification recommends a hardware-based trusted computing platform, which is a platform that uses a semiconductor device, known as a Trusted Platform Module (“TPM”), that performs protected activities, including protected storage, platform authentication, protected cryptographic processes and attestable state capabilities to provide the first level of trust for the computing platform (a “Trusted

 

12

 

Platform”).  The TPM is a hardware chip that is separate from the platform’s main CPU(s) that enables secure protection of files and other digital secrets, and performs critical security functions; such as, generating, storing and protecting “cryptographic keys,” which are secret codes used to decipher encrypted or coded data.  TCG-based systems will require an evolving “eco-system” of new development tools, applications, services and infrastructures.

 

In 2003, Wave began the market introduction of its first commercial products designed to support the emerging products that include TPMs.  Wave has developed additional products supporting these TCG products, some of which have been introduced during the second and third quarters of 2004 (see: Our Products, below).  Wave also has several other products in development that it plans to release during 2004, and will continue to develop product enhancements to products that have previously been released.

 

Wave has not realized any significant revenues since we began our operations in 1988. While Wave was successful in signing distribution contracts with Intel, National Semiconductor and ST Microelectronics, we have not begun to realize significant revenues to date from these contracts and we do not expect to begin to realize material revenues until these original equipment manufacturers (“OEMs”) begin to ship TMP-enabled products in greater quantities.  Wave and National Semiconductor Corp. (“NSC”) have since agreed to alter the way that Wave’s software is distributed to National Semiconductor’s customers, in order to allow Wave to sell directly to such customers.  Therefore, in the quarter ended September 30, 2004, Wave and National Semiconductor terminated the existing software distribution contract and negotiated an updated structure that will allow Wave to establish and maintain a direct relationship with personal computer and motherboard OEMs.  Wave continues to maintain a license agreement with NSC, whereby Wave is paid royalties based on Wave technology that is included in NSC’s chip design.

 

As the market for TPM-enabled products has begun to develop with computing devices being shipped in volume by leaders in the PC industry, Wave has enabled the development work on the EMBASSY Trust System to support security hardware based on the TCG specifications by repurposing these product assets, which has led to the development and marketing of our current products.  Wave’s products are unique in the fact that they support cross-platform interoperability for the currently available TPM chips from National Semiconductor, Atmel and Infineon and have been certified for usage on TPM platforms shipped by Intel, IBM and HP. However, our revenues have been nominal in relation to our expenditures due to the early stage nature of the market for computers that utilize TPMs coupled with our applications to perform information security functions.  As a result, we have experienced a slow pattern of corporate development.

 

Wave is devoting its resources to capitalize on the opportunities presented by this developing market, and overcoming the specific challenges in achieving this goal.

 

The market trends and opportunities that management focused its activities on during the quarter ended September 30, 2004 included the following:

 

•                  The market for information security services is growing rapidly.  According to industry analyst, IDC, the U.S. market for information security services is expected to grow from approximately $4 billion in 2001 to $10.7 billion in 2006 representing a compound annual growth rate of 21.7%.  The global market for information security is expected to reach $23 billion by 2006.¹

 

•                  The persistence of security threats indicates that hardware is needed to provide more robust security than traditional software solutions.

 

•                  There is an emergence of TPM-enabled PCs being sold into the marketplace.  This emergence is complementary to Wave’s business model, which largely relies upon providing services for Trusted Platforms rather than selling the hardware itself.

 

•                  Business and security strategies are becoming more closely aligned due to the increasing rate of significant high profile and costly security breaches and the associated risks presented by this phenomenon.

 

•                  In-house security expertise remains in short supply.  Wave seeks to capitalize on its expertise as awareness of TPM-enabled solutions increases.

 

¹ IDC, The Shifting Landscape: U.S. Information Security Services, Jan. 2003, document # 28640.

 

13

 

In pursuing these opportunities, we recognize many significant challenges that must be overcome, including:

 

•                  Tight enterprise IT budgets – industry data appear to show that while enterprise security will be a priority, it will be challenged by tight budgets.

 

•                  Long sales cycle due to continued lack of support for enterprise spending on security solutions – information security continues to be viewed as an IT issue versus a business issue.

 

•                  Market awareness – need to educate the marketplace of the advantages of utilizing hardware trusted platforms as a security solution.

 

•                  Limited availability of capital resources – Wave continues to rely on financing the development of its business by issuing new equity.

 

As more PC and chip OEMs have begun introducing their Trusted Platform offerings, management has focused on licensing contracts in which the OEM licenses our applications or technology as part of their offering, paying Wave a royalty for each unit shipped. Wave currently has signed such agreements with three separate OEM partners: National Semiconductor, ST Microelectronics and Intel.  Although no significant revenue has been recognized on these contracts through September 30, 2004, we believe that revenues will increase in future periods based on licensing contracts that Wave signed with customers in the quarter ended September 30, 2004, and the increasing trend in shipments of TPM products shipped by our OEM customers compared to the quarter ended June 30, 2004.

 

In addition, we have sought to develop our products such that they operate on all of the major chip OEM Trusted Platforms that are currently shipping product in the marketplace and our applications have been approved to work with the Trusted Platforms of IBM, HP, Atmel, Infineon and others.

 

Management is also focused on developing the client and server-side applications and tools that will enable enterprises to manage an IT infrastructure that relies on TCG hardware-enabled security.  Wave is devoting a significant portion of its research and development budget to address this opportunity, as this will be a key ingredient for enterprises to successfully implement a Trusted Platform solution.  Wave has begun to offer these tools and applications in 2004.

 

With respect to sales and marketing, management is focused on broadening our distribution strategies to include resellers and systems integrators and expanding our presence selling directly to OEMs.  We have re-organized and shifted the focus of our sales force during the latter part of 2003, in order to achieve these objectives.  To date, we have signed agreements with four resellers, CSS Laboratories, Envoy Data Corporation, SmartAxis, SA and Techscaler, Inc., for our software applications.  These agreements do not specifically obligate these resellers to purchase any minimum quantities of Wave products; however, they have agreed to promote and solicit orders for our products.

 

Management is also focused on opportunities for its eTM product suite to provide digital signing and document management solutions to the financial services and other vertical markets in which there is a clear and identifiable value proposition in implementing these solutions.  Although we have met significant implementation challenges and long sales cycles with this effort, we have also experienced significant interest in these products and we continue to pursue this opportunity.

 

With respect to Wavexpress’ secure broadband media distribution products and services, the first revenue-producing contracts were entered into during the year ended December 31, 2003, and Wave began realizing revenue starting in the third quarter of 2003.  Wavexpress continues to focus on sales and marketing activities and has signed additional contracts late in 2003 and during the first quarter of 2004.  We believe that these contracts will generate revenue over future periods as well.

 

While management has committed to pursuing the business opportunities and objectives described above, it recognizes significant risks that are involved with pursuing its strategy.  Hardware-based computer security is but one approach to information security, and one that has significant hurdles to overcome.  There remains a high level of uncertainty as to whether hardware-based computer security will become a major category within the information security market, how large this category will be in terms of sales

 

14

 

value and the length of time that it may take for these products to become a widely utilized information security solution.

 

Our Products

 

Desktop Applications and Tools

 

The EMBASSY Trust Suite

 

The current version of the EMBASSY Trust Suite is a set of applications, tools and services that are designed to bring functionality and user value to the TPM-enabled products.  The EMBASSY Trust Suite includes the EMBASSY Security Center, Document Manager Vault, Private Information Manager (“PIM”), SmartSignature and Key Transfer Manager (“KTM”).  The EMBASSY Security Center is an application for TPM management and user authentication functions that includes features such as Windows logon preferences to add biometrics.  Document Manager Vault, which integrates with Microsoft Office and Windows Explorer, provides document encryption, decryption and client-side storage of documents and secures documents against unauthorized users and hackers.  PIM uses the TPM to securely store user information such as user names, passwords, credit card numbers and other personal information.  It retrieves login information to efficiently fill in web or application login information.  Data stored using the PIM utilizes the security of the TPM to protect against unauthorized access.  SmartSignature is a digital-signing application that utilizes the signing keys generated by the TPM.  Wave has released two separate versions of the EMBASSY Trust Suite: Professional Edition and Enterprise Edition.  The Enterprise Edition includes a client version of KTM that enables key recovery in instances of hardware failure or replacement.  The EMBASSY Trust Suite is designed to work with all commercially available TPM-enabled platforms.  Wave plans to continue to develop and enhance the current products being developed within this product group and will develop new applications and services as the trusted computing market continues to evolve.

 

EMBASSY Security Center

 

The EMBASSY Security Center application allows users to set up and configure a TPM platform.  Additionally, this application is the control center for a user to maintain their security settings, including strong authentication, secured login and simplified password management policies.  This application is available with the EMBASSY Trust Suite, but is also available separately as a standalone TPM management application.

 

TCG-Enabled Toolkit

 

The Wave TCG-Enabled Toolkit is a compilation of tools designed to assist application developers writing new applications or modifying existing ones to function on TCG-compliant platforms. Wave provides two versions of the Toolkit, Discovery and Commercial, which enable developers to leverage basic and enhanced TCG services such as integrated key lifecycle management, including key escrow and key recovery. The Discovery Toolkit offers application developers a license for internal evaluation only, whereas the Commercial Toolkit is a license for external redistribution.

 

Current planned development costs for the desktop applications product group are expected to be approximately $3.7 million for the twelve months ending September 30, 2005.

 

EMBASSY Trust Server Applications

 

The EMBASSY Trust Server applications include KTM and Attestation Credential Manager (“ACM”) — essential enablers for managing and determining authenticity of Trusted Platforms. The ACM is designed to work with any application to ensure that it is interacting with a Trusted Platform.  This is a critical function for attestation and management of TPM-equipped devices.  KTM is a server application capable of securely backing up, storing and/or migrating TCG-specific keys from one TPM-enabled system to another, according to various security policies defined on the server, in a centralized fashion.  KTM is being designed to allow an IT manager to provide capabilities to individual TPM users such as recovery services in the event of system malfunctions or new product availability. Wave plans to continue to develop and enhance the current products being developed within this product group and will develop new applications and services as the trusted computing market continues to evolve.

 

15

 

Current planned development costs for this product group are expected to be approximately $1.4 million for the twelve months ending September 30, 2005.

 

Digital Signature and Electronic Document Management

 

On October 4, 2001, Wave acquired digital signature and electronic document management technology, SmartSignature and SmartSAFE from SignOnLine, Inc., a California-based company.  This group of products now makes up our eSign Transaction Management Suite, also known as eTMS, which now consists of four core products: SmartIdentity, SmartSignature, SmartSAFE and SmartConnect.  SmartSignature Version 3.0 is a digital signature application that connects signers and institutions – banks, insurance companies, enterprises, etc. – through a legally binding digital signature.  Wave’s SmartSignature is currently enabled for the support of TPMs for added security associated with user identity and signing credentials.  SmartSAFE Version 3.0 is a web-based document management application, where signed documents are archived and tracked.  SmartSAFE provides an easy-to-use environment, where a client institution can view, manage, store and transfer sensitive signed and unsigned documents.  SmartSAFE also supports archival and management of unsigned documents in virtually any format.  These products allow a document to be executed, verified, accepted and filed in minutes at a lower cost compared to traditional documentation methods.  SmartSignature Version 3.0 and SmartSAFE Version 3.0 have been completed and Wave commercially released these products in the first quarter of 2003.    SmartIdentity, an optional service to verify a signer’s identity through strong authentication methods, including issuing encrypted digital certificates based on public key infrastructure technology, was completed and released in January of 2003.  Future development activities for this product group will be based on specific customer opportunities.  Wave will continue to allocate resources toward marketing and sales to promote these products.

 

The EMBASSY Trust System

 

Prior to the formation of the TCG, Wave developed its pioneering EMBASSY (EMBedded Application Security SYstem) Trust System.  The EMBASSY Trust System is Wave’s proprietary co-processor cryptographic subsystem and supporting infrastructure: a separate chip with its own processor designed to provide security functions; such as, hidden processing of software applications, protected storage of cryptographic keys and encrypted data that works with client and server software applications that provide and/or manage various security functions.  Products that make up the EMBASSY Trust System include hardware and software.  The hardware products that make up this product group are the EMBASSY 2100 security chip (referred to above) and secure user input devices such as EMBASSY Smart Card Readers and EMBASSY Smart Card Reader Keyboards that use EMBASSY 2100 chips.  These devices are being marketed on a limited basis to the government and military.  The software products included in this product group are the Trust Assurance Network, which is the back office security infrastructure of the EMBASSY Trust System; Assistant, a client interface that allows the user to securely enter and store their personal and financial data, personal identification numbers, passwords, digital certificates and other information that requires security; the Cyber-Comm applet, a secure French banking application that runs on an EMBASSY chip, and FINREAD, a JAVA interface for online transactions. No further development activities are planned for this product group.  The primary assets of this product group have served as the basis for the development of the TCG-compliant products in the EMBASSY Trust Suite.

 

Broadband Media Distribution

 

Wave offers its data broadband content distribution products through Wavexpress, Inc., a joint venture between Wave and Sarnoff Corporation.  The joint venture was established on October 15, 1999.  Under the joint venture 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, owned the remaining 7% of the outstanding capital stock.  The affiliates of Wave include Peter Sprague, former Chairman of Wave, and Steven Sprague, Chief Executive Officer of Wave, certain members of the Board of Directors of Wave, and certain Wave employees.

 

Wavexpress has developed a vertically integrated suite of products designed to enable the optimum broadband distribution of digital programming. Suitable media for delivery include an extensive range of file types, including video, movies and games. Wavexpress delivers files presented and assembled as rich media channels. These products are designed to provide a rich consumer experience, allow content partners

 

16

 

to participate in the market for broadband distribution and allow enterprise customers to deliver rich content to selected users within the enterprise network.  Wave believes the benefits of these products to content owners, network operators and enterprises include incremental revenue streams from content subscriptions and sales, increased consumer acquisition and retention when used as a marketing tool and cost savings over traditional distribution methods. The product has been deployed, and revenue-generating enterprise and content customers have been signed.  Planned future development expenditures are expected to approximate $1.3 million for the twelve months ending September 30, 2005. As of September 30, 2004, Wave owned 69% of Wavexpress and Sarnoff owned 25.6%.

 

Our Market

 

Software has traditionally secured critical information on networks and PCs and allowed for user access to various applications.  However, virus attacks and breaches of security have proven that software, on its own, is not capable of completely securing a network or platform.  Because of these persistent security concerns, there is now a recognized need in the computer industry for the development and deployment of a more robust and reliable security infrastructure including new security hardware in devices to guard against these persistent security risks.  The TCG was formed to develop, define and promote open industry standard specifications for embedded hardware-enabled trusted computing and security technologies, including secure hardware and software interfaces across multiple platforms, peripherals and devices.  The underlying premise of the creation of a Trusted Platform that meets the TCG specification is that only when a platform is secured by hardware, in effect creating an authenticatable security environment within the computer itself, will the information stored on the platform be adequately secure.  Wave is seeking to become a software, application and services leader in hardware-based digital security and e-commerce products markets.  Because Wave has been a pioneer in developing hardware-based computer security systems, it is distinctively positioned to take advantage of this unique knowledge, significant technology asset and trusted computing intellectual properties.

 

Because hardware-based trusted computing involves a new approach to conducting business and exchanging information using computer systems, as it will require that traditional software-based security be augmented with next generation hardware-based security and an enhanced support infrastructure, intensive marketing and sales efforts have been and will continue to be necessary, in order to generate demand for products using Wave’s technology, and to ensure that Wave’s solution is accepted in this emerging market.  The current primary focus is on closing business with chip OEM, PC OEMs, enterprise customers and systems integrators.  Wave has also undertaken steps to develop and establish a reseller channel for our products.

 

R&D

 

Wave is a development stage company and has realized minimal operating revenues since its inception.  At September 30, 2004, Wave had an accumulated deficit of approximately $264.2 million.  Wave has made a substantial investment in research and development including $1.7 million for the quarter ended September 30, 2004, and expects to continue to make substantial investments in its products and technology.  For the years ended December 31, 2003, 2002 and 2001, Wave spent approximately $7.4 million, $12.0 million and $17.7 million, respectively, on research and development activities.  In addition, Wave licensed technology and in-process research and development from Aladdin Knowledge Systems for cash and warrants valued at $3.9 million in July 1997.  From its inception in February 1988 through September 30, 2004, Wave has spent approximately $96.5 million on research and development activities.

 

Wave was incorporated in Delaware on August 12, 1988, and was known previously as Indata Corp. Wave changed its name to Cryptologics International, Inc., on December 4, 1989 and to Wave Systems Corp. in January 1993.  Wave’s principal executive offices are located at 480 Pleasant Street, Lee, Massachusetts 01238, and its telephone number is (413) 243-1600.

 

17

 

Critical Accounting Policies

 

Wave’s discussion and analysis of its financial condition and results of operations are based on its consolidated financial statements.  The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, management evaluates its estimates and judgments, including those related to revenue recognition, accounts receivable reserves, marketable securities, valuation of long-lived and intangible assets accounting for joint ventures and software development. Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

The following accounting policies are deemed critical to the understanding of the consolidated financial statements included under Item 1 - Financial Information.

 

Accounting for Warrants containing cash settlement provisions – Wave follows the FASB’s Emerging Issues Task Force pronouncement No. 00-19 (“EITF 00-19”) to account for derivative financial instruments indexed to, and settled in, our own stock.  These would include financial instruments such as options or warrants to purchase Wave stock, but does not include employee stock options.  EITF 00-19 requires that freestanding financial instruments of this nature be classified as an asset or liability at fair value, in the event that the contract underlying any such financial instruments includes a net cash settlement provision.  In addition, EITF 00-19 requires any such asset or liability to be marked to market at the end of each period, with any resulting difference in fair value to be recorded as income or loss, through Wave’s statement of operations, depending upon whether the difference results in a gain or loss.

 

On November 18, 2003, Wave granted warrants to purchase 931,309 shares of Wave’s Class A Common Stock at an exercise price of $2.62 per share, in connection with a private placement of the Class A Common Stock with a group of accredited investors.  The warrants have a three-year term.  The contract underlying the warrants includes a provision that would require Wave to pay liquidated damages in cash to the warrant holders if, at any time, the warrants are “in the money” and the registration statement registering the shares of Class A Common Stock underlying such warrants ceases to remain continuously effective. Because of this provision, the contract is considered to contain a net cash settlement provision, as defined in EITF 00-19.  Although the registration statement was declared effective by the Securities and Exchange Commission on February 12, 2004, the net cash settlement provision still applies because of the stipulation that it must remain continuously effective and there are circumstances that could potentially cause the registration statement to cease to be effective.  Accordingly, Wave recorded a liability in its balance sheet that was valued at approximately $358,000 as of September 30, 2004 and $992,000 as of December 31, 2003.

 

These values were arrived at utilizing the Black-Scholes option pricing model with the following assumptions:

 

		As of September 30, 2004		As of December 31, 2003
Expected life (years)		2.17		3
Interest rate		2.7	%	3.25	%
Volatility		127	%	121	%
Dividend yield		0	%	0	%

 

The decrease in fair value of the liability associated with the warrants of approximately $633,000 was recorded as an unrealized gain in Wave’s statement of operations in the quarter ended September 30, 2004, in accordance with EITF 00-19.

 

18