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Aladdin Knowledge Systems Ltd – ‘20-F’ for 12/31/02

On:  Monday, 6/30/03, at 1:25pm ET   ·   For:  12/31/02   ·   Accession #:  1178913-3-363   ·   File #:  0-22456

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 6/30/03  Aladdin Knowledge Systems Ltd     20-F       12/31/02    1:1.4M                                   Z-K Global Ltd/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 20-F        Annual Report of a Foreign Private Issuer           HTML   1.43M 

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 20-F

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

             For the fiscal year ended December 31, 2002.                                  Commission File No. 1-8201

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

Israel
(Jurisdiction of incorporation or organization)

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

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

None

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

Ordinary Shares, nominal value 0.01 New Israeli Shekel per share
(Title of Class)

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:

None
(Title of Class)

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

11,477,922 Ordinary Shares

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

Yes þ  No o

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

                                             Item 17 o  Item 18 þ

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

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

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

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

PART I

Item 1.               Identity of Directors, Senior Management and Advisers

Not Applicable

Item 2.               Offer Statistics and Expected Timetable

Not Applicable

Item 3.               Key Information

Selected Financial Data

The selected financial data is incorporated by reference to Item 5 of this annual report.

Risk Factors

This annual report and statements that we may make from time to time may contain forward-looking information.  There can be no assurance that actual results will not differ materially from our expectations, statements or projections.  Factors that could cause actual results to differ from our expectations, statements or projections include the risks and uncertainties relating to our business described below. 

Risk Factors Related to our Business

We have a recent history of operating losses.

We have a recent history of operating losses.  The revenue and profit potential of three of our products, eSafe, eToken and Privilege, are unproven.  All three of these products have been released recently and the revenues from these products are difficult to predict. In July 2001, we acquired certain assets of Preview Systems Inc.’s electronic software distribution business, which increased our expenses and has a history of losses.  Any revenues from our acquisition of Preview are difficult to predict.  We believe that the amount of cash and cash equivalents in our bank account is sufficient to support our current growth plans.  We have no commitments to receive additional financing and due to our recent history of operating losses, it may be difficult for us to obtain additional financing.

We face intensive competition in our industry. 

The software protection industry is highly competitive.  In the token-based software security market, our primary direct competitors are Rainbow Technologies Inc. and WiBu Systems. In addition to these primary competitors, we face competition from over twenty other software companies.  Although we believe that the features and functions of our products are favorably distinguishable from those of our competitors, we cannot be sure that we will be able to further expand our market share or that we will be able to maintain our current market share. Furthermore, we cannot guarantee that we will be successful in our efforts to develop products with innovative features and functions, or that competitive pressures will not result in price reductions that could negatively affect our business in both the token-based software security and Privilege markets.

3

The Internet security industry is also highly competitive.  Our primary competitor in the content security and anti-virus market is Trend Micro Inc. In addition, we face new competition from anti-spam companies that offer email content security solutions with plugs-ins for existing anti-virus products.   If we are unable to provide customers with prompt solutions to new viruses and vandals, our current and potential customers may choose to buy products and services from our competitors.  Since both anti-virus and anti-vandal software are adaptable to most computer systems and software, customers may change products if they determine that other products better suit their needs. 

The Internet service provider segment of the software distribution industry is very competitive.  We provide infrastructure solutions for electronic software distribution. Our primary competitor in this segment is Macrovision Corporation.  Because this is a relatively new market, in the future we may face competition from other software developers.

In addition, software developers and operating system vendors such as Microsoft have added features to new versions of their operating systems and software that are designed to limit intrusions by unauthorized users or viruses and vandals via the Internet. Furthermore, it has recently been announced that Microsoft is acquiring anti-virus technology which will eventually evolve into a fee-based service on future Windows platforms, which would increase the high-level of competition we currently face. As the incorporation of such features in future versions of operating systems and software make these systems less susceptible to outside penetration, there may be a decrease in the demand for our products. Although we believe that these solutions are less attractive than our products because they cannot be upgraded on a timely basis to address new viruses and vandals, we cannot guarantee that we will be able to convince our current and potential customers of the benefits of our dedicated anti-virus and anti-vandal solutions.

Many of our competitors have substantially greater capital resources, research and development staffs, facilities, marketing and distribution networks and name recognition as well as more extensive customer bases.  While we plan to continue to improve our products, we cannot guarantee that we will successfully differentiate our products from those of our competitors or that the marketplace will consider our products superior to those of our competitors.

We rely on independent distributors for a portion of our revenues.

Approximately 22.6%, of our revenues in 2002 were generated from sales to our independent distributors.  Although none of our distributors accounted for more than 10% of our sales, if we lose or decrease the volume of sales to our distributors, our total sales could materially decrease.  In addition, we intend to sign additional distribution agreements in the future, which may make us more dependent on our distributors.  There can be no assurance that our distributors will devote sufficient resources to market our products effectively. 

We may not be able to respond in a timely manner to our customer complaints due to our indirect relationship with some of our customers.

Although we maintain control of the distribution codes for each of our customers, our relationship with the end-users of our products is often indirect.  In many markets we primarily rely on our distributors and partners to interact with customers.  As a result, we may not learn of customer satisfaction or dissatisfaction with our products and, therefore, may not be able to respond quickly to specific market needs, which may negatively affect our results of operations.

4

We rely on a limited number of suppliers and subcontractors.

Most of the parts and components that are used to manufacture and assemble our software protection products are available from several sources, although we do purchase certain components from single source suppliers.  We believe that we have sufficient inventory of these components to meet our foreseeable needs. If we are forced to use alternative parts or components, we might have to make certain changes in the design of products that use such components, which could result in delays and interruptions in shipments and could adversely affect our operating results.  We use a single subcontractor to manufacture our proprietary application specific integrated circuits or ASICs.  Our Hardlock and Microguard lines of products also contain proprietary ASICs, which are supplied by additional single source suppliers.  If any of these suppliers cease to produce ASICs for us, the manufacturing of our ASICs would have to be transferred to another supplier or suppliers.  Such a transfer may take several months and would delay the production and supply of our products, which could seriously harm our results of operations.

Some of our production costs are fixed.

Some of our production costs are fixed costs.  Consequently, in the event of an economic slowdown that results in a decrease in the sales of our products, we will not be able to eliminate our fixed production costs.  Our inability to completely reduce our production costs in response to market trends may cause a reduction in our profit margin, which could seriously harm our results of operations. 

We are subject to several risks as a result of our international sales. 

To date, our products have been sold primarily in Europe, North America, the Far East and Israel.  We are subject to all of the risks inherent in international business activities including the following: 

In addition, if we fail to obtain approvals from foreign governmental bodies, our sales revenues and results of operations could be negatively affected.  To date, we generally have not experienced any material difficulties in collecting accounts receivable as a result of our international sales.

The spread of the SARS epidemic could seriously harm our profitability in Asia.

SARS is a Flu-like virus which first appeared in China in November 2002. To date, there have been thousands of cases reported worldwide with hundreds of fatalities. Due to the ease with which SARS can spread, medical experts recommend placing people who have contracted SARS into quarantine. People who may have come into contact with SARS are also being placed into quarantine for a 2 week period until it can be confirmed that they have not contracted SARS. Although there have been cases of SARS reported in various regions, SARS is most prominent in Asia and specifically China and Hong Kong. The spread of SARS has resulted in a business slowdown that has been felt most prominently in China. There is no way of knowing when the global spread of SARS will be brought under control. If the situation persists or worsens, it could seriously damage our sales in Asia, and particularly China.  Although the substantial majority of our sales are not made in Asia, our profitability in Asia has been hurt by the effects of the epidemic on the region.

5

If our maintenance and upgrades to our product disrupts our customers’ operations, we may suffer lost revenues and harm to our reputation.

We need to upgrade and improve our products periodically. Upgrading or deploying a new version of a product requires the cooperation of our existing customers and their network participants.  These network participants may be reluctant to upgrade our product since this process can be complicated and time consuming and poses the risk of network failures.  If our periodic upgrades and maintenance cause disruptions, we may lose revenue-generating transactions, our customers may elect to use other solutions and we may also be the subject of negative publicity that may adversely affect our business and reputation.

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

The markets for our products are characterized by rapid technological change, evolving industry standards, changes in end-user requirements and sophisticated hackers constantly improving their methods of stealing end-user technology and software.  Therefore, our future success will depend upon our ability to enhance our existing products and to develop and introduce products that achieve market acceptance.  In order to meet this challenge, we put a great emphasis on research and development. These efforts have enabled us to market three new products since September 1999 (eSafe, eToken and Privilege) and to adapt to a constantly changing market.  However, there can be no assurance that we will timely or successfully complete the development of new or enhanced products or successfully manage transactions from one product release to the next, or that our future product will achieve market acceptance.

We may not be able to protect our intellectual proprietary rights

Our success and ability to compete greatly depends on our proprietary technology.  We rely on a combination of patents and trade secrets, copyright and trademark laws, together with non-disclosure agreements, confidentiality clauses in our agreements and technical measures to establish and protect proprietary rights in our products. In addition, we currently have 17 registered patents and 31 pending applications in the United States.  We also have 2 registered patents and 30 pending applications outside of the United States.  To license our products, we primarily rely on “shrink wrap” licenses that are not signed by the customer and, therefore, we may not be able to enforce our proprietary rights under the laws of certain jurisdictions.  Although we are not aware of any material infringements of our intellectual property, we have recently become aware of and are currently investigating the possibility that one of our former Asian distributors is infringing our intellectual property. Should we come to the conclusion that our intellectual property is being infringed upon, we would take appropriate steps to protect our intellectual property. However, both in this specific case and in general, we cannot guarantee that we will successfully protect our technology because:

6

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

Significant and protracted litigation may be necessary to protect our intellectual property rights.  The software protection and Internet security industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of other intellectual property rights.  We have not completed an in-depth exhaustive analysis of such patents or applications.  Some of our competitors have extensive patent portfolios with broad claims.  As the number of competitors in the market grows and the functionality of our products increases, the possibility of an intellectual property claim against us increases.  In addition, because patent applications can take many years to be published, there may be a patent application now pending, of which we are unaware, which will cause us to be infringing when it is issued in the future. 

To address any patent infringement or other intellectual property claims, we may have to redesign our products to avoid infringement or enter into royalty or licensing agreements on disadvantageous commercial terms. We may be unable to successfully redesign our products or obtain a necessary license. In addition, any infringement or other intellectual property claims, with or without merit, which are brought against us could be time consuming and expensive to litigate or settle and could divert management’s attention from our business.  We are currently involved in one patent infringement claim (see Item 8: “Financial Information – Legal Proceedings”).

Some of the products we produce may contain undetected errors or failures

Software products as complex as those which we offer, may frequently contain undetected errors or failures, especially when first introduced or when new versions are released.  Despite the extensive product testing which we conduct, some of our products could contain software errors, defects or viruses, or otherwise fail to meet customer specifications. Any product defects in our existing or new products may result in loss or deferral of our revenues, diversion of our resources, damage to our reputation, or increased service and other costs.  In order to limit our liability, most of our end-user license agreements, our distribution agreements and reseller agreements contain limitation of liabilities clauses for indirect or incidental damages arising out of the use of our product.

Our software protection products are vulnerable to piracy.

Like the products of other developers of software security products, our software security products do not provide absolute protection against piracy.  We, together with our customers, continuously face challenges from computer hackers, who attempt to neutralize the protection our products provide in order to enable unlicensed copying of our customers’ software.  In recent years, we have faced increasingly serious hacking problems, resulting from the development by hackers of methods to circumvent some parts of our software protection products.  Such methods are often publicized over the Internet, making them readily available to those who wish to make unlicensed copies of our customers’ software.  We are constantly in the process of developing and releasing solutions designed to respond to our customers’ complaints and handle hacking problems.  Although, to date, we have been successful in developing effective solutions to these problems, we cannot guarantee that hackers will not continue to develop methods to contravene the protection provided by our products.  Failure to provide effective software protection solutions could seriously harm our business.

7

We may be subject to product liability claims by our customers.

Our Internet content security products, specifically eSafe, are designed to protect our customers’ computer systems and restricted websites from unauthorized access and from malicious and inappropriate content such as vandals, viruses and worms.  This malicious content can cause irreparable harm to our customers’ computer systems and businesses.  Although we believe that widespread hacking of our products, including eSafe, is not economically feasible based on commercially available computer equipment, should hackers manage to bypass our products’ security features, effected customers could face irreparable harm. In addition, our software protection products are used to protect software from unauthorized use; if our products are ineffective, our customers may lose substantial revenues due to software piracy. As a result of damages they incur or lost revenues, customers may bring product liability and related claims against us. Such claims brought against us, whether valid or not could negatively affect our business operating results and our reputation as well as divert management time and resources. Although most of our sales agreements contain provisions designed to limit our exposure to potential product liability or related claims, in selling our products, we rely primarily on “shrink wrap” licenses that are not signed by our customers, which may be unenforceable under the laws of certain jurisdictions. As a result, the limitation of liability provisions contained in these agreements may not be effective.

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

We have in the past grown through acquisitions. Most recently, we acquired assets of Preview Systems Inc.’s electronic software distribution business. Although, we currently have no plans for any acquisitions, this may change and the process of integrating any acquired business into our business and operations is risky and may create unforeseen operating difficulties and expenditures. The areas in which we may face difficulties include:

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

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

As a result of our research and development activities in Israel, we are required to obtain export permission from the Israeli government before exporting certain technologies.We have recently received governmental permission to manufacture and export the eToken R2 and eToken PRO. We believe that all other products we currently market do not require such approval.  However, we may require approval to sell certain products that are currently under development, including encryption technology and future versions of eToken.  In addition, Israeli encryption regulations are subject to change and updates.  We cannot guarantee that we will be successful in obtaining approvals we may apply for in the future, or that we will obtain these approvals in a timely manner; failure to obtain such approvals in a timely manner could negatively effect our business and operating results.

8

Terrorist attacks that occurred in United States on September 11, 2001, the war in Iraq and other acts of violence or war may materially affect the markets in which we operate.

In the aftermath of the September 11, 2001 terrorist attacks on the United States, the United States-led coalition of nations commenced a series of retaliatory military strikes in Afghanistan upon strategic installations of the Taliban regime, and governmental intelligence authorities issue from time to time warnings of the imminent threat of further attacks against civilian and military installations. On March 17, 2003, a coalition of countries led by the United States and the United Kingdom commenced large scale military action against Iraq with the avowed purpose of effecting a change in the Iraqi regime. Now that the war in Iraq has concluded, and the regime of Saddam Hussein has collapsed, the United States and other nations have undertaken to rebuild Iraq into a stable democratic country. These attacks, armed conflicts and their aftermath, as well as the uncertainty surrounding these issues, have had, and we expect will continue for the unforeseeable future to have, an adverse effect on the global economy, and the software industry and could result in a disruption of our business or that of our customers. In addition, these events may discourage foreign technical experts and foreign employees, upon whom we rely for support and maintenance from traveling to our facilities in Israel, which could have an adverse affect on our business performance.

Although to date our business has not been materially affected by these factors, there can be no guarantee that we will not be adversely affected in the future.

Corporate governance scandals and new legislation could increase the cost of our operations.

As a result of recent United States corporate governance scandals and the legislative and litigation environment resulting from those scandals, the costs of being a public company traded on the United States markets are expected to increase in the near future. Specifically, new legislation, such as the recently enacted Sarbanes-Oxley Act of 2002, will have the effect of increasing the burdens and potential liabilities of being a public reporting company. This and other proposed legislation may require additional management resources and increase the fees of our professional advisors as well as our insurance premiums. 

Risks Related to our Ordinary Shares

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

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

9

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

Due to the continuing weakening in the world economy, including as a result of the September 11, 2001 terrorist attacks and their aftermath, the securities markets have recently experienced volatility, which has particularly affected the market prices of equity securities of many high-technology companies, including companies having a significant presence in Israel.  This volatility is often unrelated or disproportionate to the operating performance of these companies.  These broad market fluctuations may adversely affect the market price of our ordinary shares, regardless of our actual operating performance.  Such volatility in relation to our ordinary shares may affect our ability to raise additional financing in the future.

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

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

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

If our ordinary shares were delisted from the NASDAQ National Market, we would seek to have the ordinary shares traded in the NASDAQ SmallCap Market or another national securities exchange.  However, we cannot assure you that we would be able to obtain an alternative listing for our ordinary shares.

10

Risks Related to our Operations in Israel

We benefit from certain tax benefits that may change or be withdrawn.

Four of our six expansion programs are currently eligible for certain tax benefits under The Law of Encouragement for Capital Investments (see Item 10: “Additional Information- Taxation” and Note 13d. to our Financial Statements). To be eligible for these tax benefits, we must continue to meet certain conditions, including making certain specified investments in property and equipment out of our own equity. If we fail to meet such conditions in the future, we could be required to pay certain taxes.  There can be no assurance that such tax benefits will be continued in the future, at the current levels or otherwise. The termination or reduction of certain tax benefits could have a material adverse effect on our business, results of operations and financial condition.

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

All our manufacturing facilities and our corporate and primary sales offices are located in Israel.  Accordingly, security, political and economic conditions in Israel may directly affect our business, results of operations and financial and condition.
Since the establishment of the State of Israel in 1948, a number of armed conflicts have taken place between Israel and its Arab neighbors, as well as incidents of civil unrest. In addition, Israel and companies doing business with Israel have, in the past, been the subject of an economic boycott. Although Israel has entered into various agreements with Egypt, Jordan and the Palestinian Authority, there has been an increase in unrest and terrorist activity which began in September 2000 and which has continued with varying levels of severity into 2003. Certain parties with whom we do business have declined to travel to Israel during periods of heightened unrest or tension, forcing us to make alternative arrangements where necessary. We do not believe that the political and security situation has had any material impact on our business to date as a large portion of our business is overseas; however, we can give no assurance that security and political conditions will have no such effect in the future. Any hostilities involving Israel or the interruption or curtailment of trade between Israel and its present trading partners could adversely affect our operations and could make it more difficult for us to raise capital.In addition, Israel has recently experienced a wave of unionized general strikes, in connection with economic reforms being passed into legislation. Due to the fact that our products are manufactured in Israel and, for the most part, sold to customers outside of Israel, a prolonged general strike in which ports are shut down would affect our ability to deliver our products to our non-Israeli customers. Although, we have a contingency plan that would allow us to manufacture our products in Germany, we cannot guarantee that a prolonged general strike would not have a material adverse effect on our business, results of operations and financial conditions.

Many of our employees in Israel are obligated to perform military reserve duty.

 In the event of severe unrest or other conflict, many of our Israeli male employees could be required to serve in the military for extended periods of time. In response to the increase in terrorist activity and the renewed Palestinian uprising, there has been a significant call up of military reservists, and it is possible that there will be additional call-ups in the future. While we have operated effectively despite these conditions in the past, we cannot assess what impact these conditions may have in the future, particularly if emergency circumstances arise.

11

Israeli courts may not enforce judgments rendered outside of Israel.

Service of process upon our directors and officers, all of who reside outside the United States, may be difficult to effect within the United States.  Furthermore, since the majority of our assets are located outside the United States, any judgment obtained against us in the United States may not be enforceable outside the United States.  There is doubt as to the enforceability of civil liabilities under the Securities Act and the Exchange Act in original actions instituted in Israel.  However, subject to certain time limitations, Israeli courts may enforce United States final executory judgments for liquidated amounts in civil matters obtained after due trial before a court of competent jurisdiction (according to the rules of private international law currently prevailing in Israel) which enforces similar Israeli judgments, provided that certain procedural and legal requirements are adhered to.

Item 4.               Information on the Company

History and development of the Company

Aladdin Knowledge Systems Ltd. is a leader in securing digital content, from applications software to Internet use and access.  We develop and market three lines of token-based software security systems: HASP (Hardware Against Software Piracy), Hardlock and MicroGuard. Our HASP, Hardlock and MicroGuard systems, which include both software and hardware, protect our customers’ software against unauthorized copying and illegal use by requiring software users to insert our tokens into their computers before they can use the protected software.  We also develop and market Privilege, a software distribution and licensing tool. Privilege provides a comprehensive, flexible infrastructure solution for managing, selling and fulfilling orders for software products over the Internet.  These products allow for secure software distribution over the Internet without restricting the different ways our customers do business.

We also develop and market a family of products called eSafe that provide content security solutions for Internet users.  Our Internet eSafe security products provide users with comprehensive protection against Internet content security threats such as viruses, vandals and trojans that can, among other things, destroy data, crash critical systems, redirect or “hijack” modems or steal vital information such as passwords and credit card details. 

We released the eToken R2 and the eToken Pro secure authentication devices, which are the size of a house key, and the accompanying software, eToken Enterprise.  eToken ensures that only legitimate users gain access to computers or network resources by requiring its insertion in the computer’s universal serial bus (USB) port and the entering of a single password.

Our legal and commercial name is Aladdin Knowledge Systems Ltd.  We were incorporated in Israel in 1985 and organized pursuant to the Israel Companies Ordinance, which was replaced in February 2000 by the Israel Companies Law.  Our principal executive offices are located at 15 Beit Oved Street, P.O. Box 11141, Tel Aviv, Israel 61110, and our telephone number is 972-3-636-2222.  Our Internet addresses are: http://www.eAladdin.com, and http://www.aks.com.  Information on our web site is not incorporated by reference in this annual report.

12

The following is a description of our recent expenditures, investments and acquisitions and other developments in our company:

Acquisitions

13

Investments

Business Overview

Products

Software Security

Development of software applications requires software developers to make major investments in time, money and other resources.  Software piracy denies software developers of much of the returns on their investment.  In addition, it harms paying customers, who ultimately bear a substantial portion of the cost of illegal use in the form of higher license fees.  Software piracy can occur in many forms, including:

14

According to the seventh annual independent study on global software piracy commissioned by the Business Software Alliance the global software industry’s losses due to the illegal use and duplication of business software reached $10.97 billion in the year 2001. North America, Asia, and Western Europe accounted for the vast majority (85%) of revenue losses as these regions are the predominant users of software. The countries with the highest dollar losses due to software piracy were the United States, Japan, Germany, China, France and Italy.  The total revenue loss for these countries was $6.8 billion or 62% of the worldwide losses in the year 2001. 

Due to the risk of substantial loss of revenue as a result of software piracy, software developers have a need to protect their software against unauthorized use. However, developers of low cost, “shrink wrap” software generally do not find the use of sophisticated mechanisms to protect their software cost-effective. Most users of sophisticated protection products today are software developers that sell products at relatively higher price levels, typically in excess of $200 per unit. These software developers range from smaller operations developing applications for specific vertical markets, to large software developers creating sophisticated enterprise-wide applications for distributed systems.

The need for software protection has led to the development of several methods to prevent the illegal use and duplication of software products. These methods include threats or institution of legal proceedings, which is often costly and time-consuming, and conditioning of product support on product registration.  Neither of these methods effectively prevents illegal use or duplication of software products.  Many software-based protection solutions use authorization codes to prevent unauthorized access to a program.  Authorization codes are unreliable and inconvenient, due to the need to reauthorize or reassess the program for each use and for each user on a network.

Token-Based Security Software Solutions

Our security token-based products combine proprietary software and hardware components to prevent the unauthorized use of computer software. The software component enables the developer to integrate special software procedures into a protected program either directly by accessing the software or through the creation of protected versions of the software. These procedures check whether the appropriate token is connected to the computer’s USB, parallel or serial port. Each software developer is assigned a unique code which is embedded in an ASIC contained in the token and which must be verified by the protected software before the software can be activated.

During the development cycle of the software program, the developer inserts special instructions into the program, pursuant to which the program will automatically send a code, or “challenge”, to the token at any point in the program chosen by the developer. If the appropriate token is in place, it will automatically supply the proper return code, or “response”, to the challenge, thereby enabling the protected program to continue to operate. The challenge/response procedure is transparent to the end-user if the program is being run with the appropriate token in place. However, if there is no token in place, or the incorrect token is installed, the program will not operate.  Each developer determines how the program will react to the failure to provide the appropriate response; for example, it can immediately cease operating, activate only specific modules or switch to a demonstration mode.

15

At the option of the customer, our software protection systems can also be implemented automatically - via the “Envelope” utility. This method of protection does not require the software developer to access the source code, and it is therefore available for use by software resellers. The Envelope utility creates a protected version of the original program, which will only run if the appropriate token is connected to the computer.

We believe that our token-based software security product lines offer several advantages compared to other software security devices, including other hardware-based devices manufactured by our direct competitors. These advantages include:

We currently offer three lines of token-based software security systems: HASP, Hardlock and MicroGuard.

16

HASP Product Line

Our initial software security product was HASP.  The standard HASP model has undergone several upgrades and we now market it as HASP4.  This token offers the primary security features that we develop, including an advanced ASIC chip with an on-chip encryption engine, an Envelope tool for automatic protection and an Application Programming Interface (API) for customized protection.

The following are our principal HASP4 products that support Windows 3.x, 95/98/ME/2000/NT/XP, Linux, Mac OS 8.6-9.x and Mac OS 10.x.:

HASP4 Standard: HASP4 Standard is a low cost and high security solution. Using all the state-of-the-art techniques included in the HASP system, HASP4 Standard offers an extremely secure, yet surprisingly low-cost solution for software developer’s protection needs. HASP4 Standard is available in parallel and USB versions. The USB version is a true cross platform solution that supports Windows, Linux and Mac operating systems.

HASP4 M1 and HASP4 M4:  HASP4 M1 and M4 combine the inherently high level of encryption-based security with the flexibility of up to 496 bytes of secured read/write memory and a unique ID number for every key. In-the-field upgrading capabilities of HASP4 M1 and HASP4 M4 help software developers implement their business strategy by enforcing sales models such as demo and try-before-you-buy, for up to 112 applications – all in a single key. HASP4 M1 and M4 are available in parallel and USB versions. The USB versions are cross-platform solutions that support Windows, Linux and Mac operating systems.

HASP4 Net: HASP4 Net is the most advanced system available for protecting software running on networks. Just a single HASP4 Net is required to activate a protected application from any of the stations in a network. HASP4 Net supports TCP/IP, NetBios and IPX protocols. HASP4 Net is available in parallel and USB cross-platform versions.

HASP4 Time: HASP4 Time is a HASP4 M4 key that contains a real-time clock, especially designed for protecting demonstration, try-before-you-buy and subscription versions of software developer’s applications. Users can limit time execution of the application according to dates, schedules or leasing periods. HASP4 Time is available in parallel and USB cross-platform versions.

HASP4 PC-Card: HASP4 PC-Card is a PCMCIA (Personal Computer Memory Card International Association) version of HASP4 M4. Based on the PCMCIA Type-1 standard, it is specially suited for securing software that runs on laptops and requires an unobtrusive protection solution.

AladdinCard: AladdinCard is a special parallel card that lets software developers install parallel software protection keys (by any manufacturer) safely inside the PC.

Hardlock Product Line

Following are our principal Hardlock products, which support Windows 95/98/ME/2000/XP and Linux:

Hardlock Twin: The Hardlock Twin is an ASIC-based token with variable response protection.  Its powerful encryption capability provides effective software protection. The Hardlock Twin, built double-sided, plugs into a parallel or serial port, offering flexibility. Hardlock Twin is available with 128 bytes of memory (e.g. for management of multiple applications) and without memory. 

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Hardlock E-Y-E: The Hardlock E-Y-E contains the functionality of the Hardlock Twin, but is configured for use only on the parallel port. Hardlock E-Y-E is available with or without 128 bytes of memory. 

Hardlock PCMCIA: The Hardlock PCMCIA contains the same features as the Hardlock Twin, but is configured for the PCMCIA/PCCard interface. Hardlock PCMCIA is a Type II PCCard and is available with or without 128 bytes of memory.

Hardlock-On-Card: The Hardlock-On-Card has the functionality of Hardlock Twin with the benefit of being an add-on board, which can be plugged into ISA or PCI Microchannel buses. The Hardlock-On-Card is available with or without 128 bytes of memory.

Hardlock Server: Hardlock Server is a Hardlock key that protects software running on networks. Just a single Hardlock Server is required to activate a protected application from any of the stations in a network. Hardlock Server supports TCP/IP, NetBios and IPX protocols and is available in parallel and USB versions.

Hardlock USB: The Hardlock USB contains all the features of the Hardlock Eye, but is designed for the USB port instead of the parallel port. 

Hardlock SE: The Hardlock SE is a software protection token for the serial port.  The Hardlock SE offers a flexible cross-platform protection solution for software vendors developing applications for UNIX workstations, as well as for IBM PCs and their compatibles.

Microguard Product Line

The following are our Microguard products:

Microguard Plus: Microguard Plus is a microcontroller-based USB token designed for the Macintosh environment.  Microguard Plus is available with 128 bytes of memory or with 624 bytes of memory.  Microguard Plus is offered both in single user and in network models.

Microguard PC: Microguard PC is a parallel port connection token for PCs.   It contains 158 bytes of memory.  Microguard PC is offered both in single user and in network models.

Internet Content Security Products

Today’s anti-virus software products are able to cope with all existing and known viruses and virus technologies. The penetration and success of the Internet and its innovative active content technologies such as Java, ActiveX and HTML scripts have created a new type of Internet-specific threat collectively called malicious content or Vandals. Unfortunately, existing anti-virus software products are not designed to deal with these new threats. As opposed to viruses, vandals are auto-executable applications that “hit-and-run.” They do not linger in the user’s computer in order to replicate themselves.  Since vandals are usually unknown, standard methods of scanning for known virus patterns do not work and there is a clear need for a Proactive Content Security solution.

Signature-based anti-virus software has been widely used since 1990 and today more than 90% of corporate users have some sort of anti-virus protection deployed throughout their organization. However, anti-virus software operates by scanning files and trying to detect the signature of viruses from the database of known viruses and relies heavily on the anti-virus vendor that must continue to update the database in a timely manner in order to be protected against the new viruses. In the Internet age, one cannot afford to be reactive and risk becoming the first victim to be hit. Since dangerous vandals now travel at the speed of light, there is absolutely no chance that we can analyze them in time and update everybody before they can strike. Proactive solutions that provide real-time protection against unknown potential threats by enforcing content security policies at the gateway level are therefore critical.

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     eSafe Family of Products

The eSafe solution is based on a multi-tiered content security architecture, protecting the Enterprise on the following levels:

     eSafe Gateway

eSafe Gateway is a proactive content security and an anti-virus solution for Internet gateways, eSafe Gateway manages Internet-borne information flow based on corporate policies for content that is inappropriate, nonproductive or contains malicious code such as vandals, viruses and worms. eSafe Gateway supports HTTP (web browsing), FTP (file download), and POP3/SMTP (email) protocols and can be configured to operate in any network with or without a firewall.  

The following are eSafe Gateway’s unique features:

     eSafe Mail:

eSafe Mail is a powerful proactive email security and anti-virus solution. eSafe Mail protects Microsoft Exchange servers, by scanning and cleaning both private and public mailboxes, as well as standard email (SMTP) traffic to and from any mail servers. It manages email traffic based on corporate policies for blocking and scanning dangerous attachments, viruses, malicious scripts, spam, spoofed mail, and other hostile content.

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The following are eSafe Mail’s unique features:

     eSafe Appliance

eSafe Appliance is the industry’s first content security and anti-virus gateway and mail inspection product that is compliant with OPSEC (Open Platform for Security), the industry’s open, multi-vendor security framework. It operates as a dedicated server, pre-loaded with a hardened Linux OS and eSafe Gateway or Mail content security applications. It fits easily into any existing security infrastructure for an integrated, high-quality and cost effective solution.

     eSafe’s Unique technologies

     MacroTerminator™

By using pattern-matching exact behavior analysis (heuristic algorithms), MacroTerminator is capable of detecting, with a high degree of accuracy, macro viruses that are so new that they have not yet been individually analyzed. Macro viruses are written in a high-level VBA (Visual Basic for Applications) language. High-level languages are subject to heuristics, which enables high accuracy of hostile activity detection, while maintaining an extremely low level of false positives (false alarms). Macro Terminator can recognize all known malicious macro families (such as Melissa), and therefore can block the majority of new, yet unknown variants/mutations of these families. Macro Terminator also has a high detection rate of new, unknown malicious macros, which are not variants of known macro families.

     GhostMachine™

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

     SmartScript™ Filtering

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

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     Smart Script filtering can recognize all known malicious script families and can therefore block majority of new, yet unknown variants/mutations of these families. It also has a high detection rate of new, unknown malicious scripts, which are not variants of known script families.

     XploitStopper™

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

     NitroInspection™

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

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

     Anti-Spam

Spam is growing rapidly. It is estimated that over 50% of today's business email is spam. Spam forces Internet service providers to cope with increasing amounts of email traffic, and the bandwidth of businesses is largely consumed by it, impacting resources and productivity. According to International Data Corporation, spam is no longer just a nuisance; it is quickly becoming both a potential legal liability and a major productivity drain for both corporate information technology departments and corporate users. Spam not only drains worker productivity and consumes valuable information technology resources such as disk storage, central processing unit cycles, and network bandwidth, but it can also expose the organization to legal liability due to the offensive nature of some messages. We provide solutions to these problems by utilizing multiple layers of anti-spam technology ranging from basic solutions that are built into our product to offering our customers a sophisticated anti-spam service, which is based on our original equipment manufacturer (OEM) relationship with Cobion, a German company that specialized in anti-spam and web filtering technologies.

     eToken Products

The growth of both the Internet and mobile computing are continuously challenging and redefining data security requirements. Corporations are caught between the need for remote, convenient access and the need for protection from vandalism, espionage and theft. Conventional password schemes alone are not effective in protecting systems from outsiders or user negligence. 

During 1999 and 2000, we released the eToken R2 and the eToken Pro, secure authentication devices which are the size of a house key, and the accompanying software, eToken Enterprise.  eToken ensures that only legitimate users gain access to network or PC resources by requiring that the token be inserted into the computer’s USB port before allowing the computer to operate. Our eToken technology offers users several network and Internet security tools, including authentication, encryption and secure certificate storage capabilities, all housed within the small, portable eToken.  In addition, eToken provides user flexibility in deployment through advanced smartcard technology.  eToken’s versatile architecture  enables organizations  to  use  both existing authentication systems  or introduce new ones  based  on  advanced  technology,  while maintaining a similar end-user experience. Support for standard security interfaces, coupled with the ability to cache user passwords, enables the eToken solution to be operated with almost any authentication system.

Our eToken technology allows for concurrent storage of multiple private keys, passwords and digital certificates for use in a wide variety of applications. eToken can be used as an authentication device for e-banking, virtual private networks, extranets and wide area networks and as an enabler for e-Commerce. eToken serves as an encryption device that enables companies to verify the identity of individuals who request access to protected content or applications provided over their networks or websites.  eToken can be used to protect sensitive data and resources by performing file encryption and access control functions. eToken can also be used in conjunction with third-party software to digitally sign and/or encrypt electronic messages so that they cannot be modified or intercepted. eToken does not require an additional reader to effectively control any user within the network.  eToken links to USB ports in PC’s and laptops of all major manufacturers.

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International Data Corporation predicts  that  USB  tokens  and  smartcards will become interoperable because  USB  tokens  also  have  PKI  (Public Key Infrastructure) and  digital-certificate capability.  As the technology develops, USB keys will be able to provide  an  integrated  solution  that  could  only  previously  have been provided  through  separate  authentication  devices.  We are currently developing expanded functionality for the eToken in order to simplify password management by allowing the eToken to store multiple credentials, such as digital certificates to simple passwords, which can easily be retrieved from the token without user interaction.

               Internet Software Distribution Products

Privilege Software Commerce Platform

We believe that the Privilege Software Commerce Platform (SCP) is one of the most comprehensive and flexible infrastructure solutions for managing, selling, and distributing software over the Internet.  Through digital delivery, software is immediately and widely accessible, always in stock, and up to date.  In addition, digital delivery of software saves printing, packaging and shipping expenses, inventory and warehousing costs, while ensuring the protection of our customer’s intellectual property.

Privilege SCP is composed of three principle components:

The Builders –a suite of tools (some standard and some optional) that prepare software for electronic distribution, add mechanisms for protecting intellectual property, and set usage rights for software after it is installed.

The Commerce Server – the “back-end” component that manages and warehouses the digital inventory, and ensures secure, automated, and reliable fulfillment of software product and license orders.

The Storefront Engine – the “front-end” component that provides an access mechanism from a merchant’s on-line storefront to software warehoused on Commerce Servers, in order to sell and distribute software products to consumers.

The architecture of Privilege SCP allows for the Storefront Engine to be operated either by a software publisher for direct sales or by an on-line reseller/retailer for “channel” sales.  The Commerce Server is operated by either a software publisher or a software distributor.  A Storefront Engine can connect to multiple Commerce Servers and a Commerce Server can connect to both multiple Storefront Engines and other Commerce Servers, creating a virtual software supply chain.

Privilege SCP is tailored to the customer’s requirements based upon the core technology and the latest product release. In general, Privilege SCP enables software publishers, distributors, and retailers to:

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We recently released Privilege SCP 5.0, which supports software delivery to and protection on the Windows XP or Macintosh OS X platforms.

Our business is not dependent on patents or licenses.

Marketing and Promotion

We conduct a number of marketing programs to support the sale and distribution of our products. These programs are designed to inform existing and potential customers about the capabilities and benefits of our products. Our marketing activities include:

We sell our products directly, including through our website, through subsidiaries, value-added resellers, original equipment manufacturers and through independent distributors in over 50 countries worldwide.  We believe that our success and ability to market our products will depend, to a significant degree, on our subsidiaries and independent distributors and resellers.  In the years ended December 31, 2002, 2001, and 2000, approximately 22.6%, 19.4% and 18.5%, respectively, of our consolidated revenues were generated from sales to our independent distributors. During these periods, no single distributor accounted for more than 10% of our sales.  We generally have short-term written agreements with our distributors and resellers, all of which are non-exclusive.  If we lose or decrease the volume of sales to some of our distributors and resellers, our total sales could materially decrease. 

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In 2001, we entered into distribution agreements with leading distributors in Europe (Articon-Integralis) and the United States (Westcon Group).  We have continued our relationship with these distributors in 2002 and into 2003.  The Alasso unit of Articon-Integralis was recently sold by Articon-Integralis to InTechnology plc and we have maintained our relationship with Alasso.  We have also entered into an agreement with Digital River, Inc.  which allows us to offer our products and services to their customers at our standard rates. We intend to continue to target resellers and system integrators that focus on providing security solutions to enterprises. In addition, we have launched Aladdin Security Alliance, our solution partner program. In this program we present joint solutions that are offered to the market by both our partners and our distribution channels. These distribution channels include vendors in areas such as PKI, VPN (Virtual Private Network), Access Control, Web Access, PC Security and more. However, there can be no assurance that we will successfully establish new distribution arrangements, or that any of our distributors will devote sufficient resources to market and distribute our products effectively. In addition, since we rely on distributors, we have an indirect relationship with consumers of our products in many markets. As a result, we may not learn of customers’ satisfaction or dissatisfaction with our products and may not respond quickly to specific market needs, which may negatively affect our results of operations.

Maintenance and Support

We believe that providing a high level of customer service and support is essential to our success. Outside of Israel, the first-line of support is provided by our subsidiaries and distributors, while we provide the second-line of support.

Software Security Products

We, together with our subsidiaries and distributors, provide maintenance and support services for our software security products free of charge.  These maintenance and support services include a “hot-line” telephone number that can be used by customers during business hours to assist them in solving problems.  We also support customer inquiries via fax and e-mail, and provide additional technical information on our Internet home page. In addition, software developers who have purchased our token-based software security products can download software updates from our FTP (File Transfer Protocol) Internet site free of charge.

Internet Security Products

We generally provide maintenance and support services for our Internet security products during the first 12 months following the installation of the product, depending on the terms of each particular sale and the warranty that we provide.  These maintenance and support services include a “hot-line” telephone number during business hours, fax and e-mail support and product updates.  After the expiration of the warranty period, each of our Internet security customers is offered a long-term maintenance agreement with us, or with one of our subsidiaries or distributors, as the case may be. These maintenance agreements include the same services provided during the warranty period. The maintenance agreements generally have one-year terms and in some cases are automatically renewable.

eToken

We generally provide a 12-month manufacturer’s warranty on our eToken hardware product.  During this warranty period, we replace any eToken that fails as a result of a recognized manufacturers defect with a like replacement. We provide eToken users with technical support via phone, fax and e-mail from our Tel Aviv headquarters and through all our subsidiaries.  We also offer a comprehensive Web site containing technical support information on eToken.

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Privilege

The license agreement for Privilege SCP includes a maintenance and support component.  The standard maintenance and support package provides free access to product updates along with access to our support center in Portland, Oregon during set hours.  The support center is accessible to our customers via e-mail or telephone.  For those customers who require round the clock support, an enhanced support package is available.  This enhanced package provides 24 hour coverage with maximum response times.

Managed Privilege is our managed service which hosts the software publisher’s store. Our Managed Privilege customers receive up to three levels of support.  The first level includes free access to product updates along with access to our support center.  The second level includes various management and administrative options to ensure Web site availability, prepare products for distribution, and track the success of product promotions.  The third level can include end-user support for download problems and/or product returns where calls are answered under our customer’s name.

Government Controls

As a result of our research and development activities in Israel, we are required to obtain export permission from the Israeli government before exporting certain technologies.We have recently received governmental permission to manufacture and export the eToken R2, and eToken PRO. We believe that all of the other products that we currently market do not require such approval.  However, we may require approval to sell certain products currently under development that include encryption technology as well as future versions of eToken.  We cannot guarantee that we will be successful in obtaining approvals we may apply for in the future, or that we will obtain these approvals in a timely manner. 

Sales of our products in Europe are subject to various regulations, including directives adopted by the European Community. These directives provide, among other things, that we comply with International Standard ISO 9000 (European Standard EN 29000) entitled “Model for Quality Assurance in Design, Development, Production, Installation and Servicing.”  In 1997, we received ISO 9002 certification, which is valid until October 2003 and we recently received ISO 9001-2000 certification, which is valid until March 31, 2006. We have consistently passed the semiannual ISO audit.   

In addition, we receive certain tax benefits and reduced tax rates from the government of Israel (See Item 10: “Additional Information - Taxation.” and Note 13d to our Financial Statements).  The entitlement to these benefits is conditional upon our fulfillment of the conditions stipulated by the law, regulations published thereunder and the instruments of approval for the specific investments including investments from equity.  In the event of a failure to comply with these conditions, the benefits could be canceled and we would be required to refund the amount of benefits, in whole or in part, with the addition of linkage difference and interest.

Customers

We sell our software security products primarily to software developers and distributors.  No one customer accounted for more than 10% of our net sales in 2002, 2001 and 2000.  The following is a breakdown of our sales by geographic market:

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*Includes customers for product lines acquired in the Preview acquisition.

Manufacturing, Testing and Suppliers

Our manufacturing, system integration and testing operations for our HASP, Hardlock, Microguard and eToken products are located in Kiryat Gat, Israel. Certain components of our Hardlock line of products are manufactured on a sub-contracting basis in Germany. 

Our HASP and Hardlock manufacturing operations consist primarily of assembling finished goods from components.  We seek to monitor quality with respect to each stage of the production process, including the selection of component suppliers, the assembly of finished products and final testing, packaging and shipping. We use an automated surface-mounted technology to produce substantially all of our HASP, Hardlock and eToken products. We perform testing and quality assurance procedures with respect to the components and subassemblies, which are incorporated into our final products and with respect to the final products ourselves. We believe that our in-house manufacturing capabilities with respect to our HASP, Hardlock and eToken product lines have been instrumental in achieving a high degree of reliability for our products.

We generally fill our typical order for products within several hours to several days after receipt of a firm purchase order. Due to the nature of our sales and marketing efforts and our close contact with our customer prior to the receipt of a purchase order, we can often plan production and order the components necessary to enable us to deliver products in a relatively short time after our receipt of a purchase order.  

Most of the parts and components that we use to manufacture and assemble our products are available from several sources, although we do purchase certain components from single source suppliers and prices may fluctuate due to changes in the market.  Currently, we buy most of our raw materials from Philips, Elmos, Fairchild, Seiko, Infinion, Cypress and Samsung. To ensure the supply and price of components which we purchase from single source suppliers, these components are purchased under long term contracts with our suppliers that ensure supply and price for periods of a year and more. We also hold safety stocks of such components to ensure steady supply in the event our supplier experiences difficulties or delays. Furthermore, we split the storage of critical components amongst different locations to ensure that there is always a readily available supply of critical components.

Organizational Structure

We have three wholly owned subsidiaries: Aladdin Knowledge Systems, Inc., a United States subsidiary incorporated in the state of New York; Aladdin Japan & Co. Inc., a Japanese subsidiary; and Aladdin Western Europe Ltd. (formerly known as Aladdin Knowledge Systems UK Ltd.), a United Kingdom subsidiary incorporated in England and Wales. These subsidiaries are all involved in distribution, support and management for our products.

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In addition we have a wholly owned holding company, Hafalad BV, which is incorporated in Holland.  Through Hafalad we wholly own Aladdin Western Europe BV (formerly known as Aladdin Knowledge Systems BV), Aladdin Western Europe (Aladdin France S.A.R.L.) (formerly known as Aladdin France S.A), Aladdin Knowledge Systems Deutschland GmbH and Aladdin Knowledge Systems Verwaltung GmbH.  Aladdin Knowledge Systems Deutschland GmbH and Aladdin Knowledge Systems Verwaltung GmbH are both incorporated in Germany and are the sole partners in Aladdin Knowledge Systems GmbH & Co. KG. Aladdin Western Europe BV is incorporated in Holland and Aladdin Western Europe (Aladdin France S.A.R.L.)  is incorporated in France. We are currently in the process of reorganizing the management of activities in France, the Netherlands and the United Kingdom, under the single management of Aladdin Western Europe Ltd. In addition to engaging in distribution, support and management, our German subsidiaries and Portland, Oregon office provide research and development services.

Property, Plants and Equipment 

Our executive, research and development offices and certain of our production facilities are located in Tel Aviv, Israel. We currently lease a total of approximately 2,300 square meters of space from an unaffiliated entity, at an aggregate base monthly rent of approximately $15,000, which lease expires in 2006 with an option for one additional year.

Most of our production facilities are located in Kiryat Gat, Israel.  We currently lease a total of approximately 976 square meters in Kiryat Gat, which lease expires on September 30, 2005, for an aggregate monthly rent of approximately $6,300.   In addition, we lease approximately 725 square meters in Haifa, Israel, where our Internet security research and development activities are headquartered, at a monthly rent of approximately $7,200.  Our lease in Haifa expires on February 29, 2004.

We lease space for our operations in the United States, Germany, United Kingdom, Japan, the Netherlands and France.  Aggregate monthly lease payments under these leases are approximately $67,000.  Our leases in these locations expire between 2004 to 2007.

Our aggregate lease expenses (including motor vehicles) for the years 2002, 2001 and 2000 were $2,514,000, $2,423,000 and $1,375,000, respectively.   We believe that our facilities are adequate for our current needs.  In the event that additional facilities are required, we believe that we could obtain such additional facilities at commercially reasonable prices.

Item 5.               Operating and Financial Review and Prospects

Critical Accounting Policies

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

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

Revenue recognition. Our products are generally a bundled hardware and software solution that are delivered together. Revenues from products are recognized in accordance with Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial Statements” (“SAB No. 101”) when the following criteria are met: persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is fixed or determinable, collectibility is probable and we do not have any obligation to customers after the date in which products are delivered.

We generate revenues from licensing the right to use our software products directly to end-users and indirectly through resellers (both of whom are considered end users), from the sale of products, maintenance and updates.

Revenues from software license agreements are recognized, in accordance with Statement Of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended, upon delivery of the software, when collectibility is probable, the license fee is fixed or determinable, vendor-specific objective evidence (“VSOE”) of fair value exists to allocate the appropriate fee to undelivered elements of the arrangement, persuasive evidence of an arrangement exists and no further significant obligation remains.

Where software arrangements involve multiple elements, revenues are allocated to each element based on VSOE of the relative fair values of each element in the arrangement in accordance with the “residual method” prescribed by SOP 98-9 “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions”. Our VSOE which we use to allocate the sales price to updates and maintenance is based on the price charged when these elements are sold separately. License revenues are recorded based on the residual method. Under the residual method, revenues are recognized for the delivered elements when (1) there is vendor-specific objective evidence of the fair values of all the undelivered elements and (2) all revenue recognition criteria of SOP 97-2, as amended, are satisfied. Under the residual method any discount in the arrangement is allocated to the delivered element.

Revenues from maintenance and updates are recognized over the term of the agreement.

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

Accounts Receivable. We are required to perform ongoing credit evaluations of our trade receivables. We maintain an allowance for doubtful accounts. Management exercises its judgment as to our ability to collect outstanding receivables. Provisions are made based upon a specific review of all the outstanding invoices.In determining the provisions, we analyze our historical collection experience and current economic trends.

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

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Deferred tax. We record a valuation allowance to reduce our deferred tax assets to the amount that we believe is likely to be realized. In assessing the need for a valuation allowance, we consider all positive and negative evidence, including reversals of existing deferred tax liabilities, estimated future taxable income, prudent and feasible tax planning strategies, and recent financial performance. Due to the history of losses in our subsidiaries (except Germany) and the estimation that it is more likely than not that the net deferred tax assets related to our subsidiaries’ loss carry-forwards will not be utilized, we concluded that a full valuation allowance of $9.7 million against our net deferred tax assets related to our subsidiaries’ loss carry-forwards, at December 31, 2002 was appropriate. If, in the future, we believe that a deferred tax asset will be realized, for which we currently have a valuation allowance, we will be required to reverse the valuation allowance, which could result in an income tax benefit in the period of such determination. 

Goodwill. Under Statement of Financial Accounting Standard No.142, “Goodwill and Other Intangible Assets” (“SFAS No, 142”), goodwill acquired in a business combination which closes on or after July 1, 2001 is deemed to have indefinite life and will not be amortized. SFAS No.142 requires goodwill to be tested for impairment on adoption and at least annually thereafter or between annual tests in certain circumstances, and written down when impaired, rather than being amortized as previous accounting standards required. Goodwill is tested for impairment by comparing the fair value of the reporting unit with its carrying value. Fair value is determined using market multiples and comparative analysis. Significant estimates used in the methodologies include estimates of market multiples for the reportable unit. We have performed impairment tests on our goodwill and as of December 31, 2002, no impairment losses have been identified.

Selected Financial Data

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (‘GAAP’).

We derived the selected consolidated statements of operations data set forth below for the years ended in December 31, 2000, 2001 and 2002, and the selected consolidated balance sheet data as of December 31, 2001 and 2002, from our audited consolidated financial statements, which are included elsewhere in this annual report. We derived the consolidated statements of operations data for the years ended December 31, 1998 and 1999 and the selected consolidated balance sheet data as of December 31, 1998, 1999 and 2000 from audited consolidated financial statements that are not included in this annual report. Please see Note 2 to our Consolidated Financial Statements for a discussion of our significant accounting policies.

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The tables that follow present portions of our financial statements and are not complete. The following selected financial data should be read in conjunction with our consolidated financial statements and notes thereto, included in this annual report. Historical results are not necessarily indicative of any results to be expected in any future period.

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Operating Results

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

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

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

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

Research and development expenses.  Research and development expenses consist primarily of compensation and related costs of employees engaged in on-going research and development activities, costs of subcontractors and related expenses. Research and development expenditures increased 11.2% to approximately $13.8 million during 2002, as compared to $12.4 million during 2001.  As a percentage of revenues, research and development expenses, increased to 27.9% in 2002 from 26.7% during 2001.  This increase was due to an increase in compensation expenses resulting from the hiring of new research and development personnel, primarily for the development of eToken and for our new research and development center that we opened in connection with the Preview acquisition. We expect to expand our research and development efforts, and we are currently developing new products that incorporate both technology presently used in our products and technology that we are developing for new applications.

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

General and administrative expenses. General and administrative expenses consist primarily of compensation for finance and human resources, allowance for bad debt, good will amortization as well as professional service expenses. General and administrative expenses decreased to approximately $5.7 million during 2002 as compared to $7.5 million during 2001.  As a percentage of revenues, general and administrative expenses, decreased to 11.4% in 2002 from 16% during 2001.  This decrease in general and administrative expenses resulted primarily from the fact that goodwill amortization in 2002 decreased by $1.96 million as compared with 2001. This decrease in goodwill amortization was due to  our adoption of SFAS No. 142, “Goodwill and Other Intangible Assets”, whereby  we ceased amortizing goodwill and performed an annual impairment test in accordance with SFAS 142 (see Note 2 to our consolidated financial statements).

Restructuring charges. As a result of the downturn in the global economic conditions, the decline in overall business levels and the related impact on our operations, we implemented during 2002 a worldwide restructuring and cost reduction plan, including at the level of our subsidiaries. In 2002 we, together with our subsidiaries, recorded expenses of approximately $1.12 million, associated primarily with a reduction in work force and general reduction in all operating expenses.

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

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

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

Taxes on income. Taxes on income were approximately $2.7 million in 2002 compared to approximately $(347,000) in 2001. Taxes on income in 2002 were primarily due to an income tax provision from ongoing operations of approximately $200,000 and due to the increase of the valuation allowance for deferred tax assets of approximately $2.5 million.  We believe that it is more likely than not that the deferred tax regarding carry-forward losses will not be utilized. Taxes on income in 2001 were primarily due to an income tax provision from ongoing operations of approximately $146,000 and deferred tax income of approximately $(493,000) regarding carry-forward losses.

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Year Ended December 31, 2001 Compared to Year Ended December 31, 2000

Revenues. Revenues increased approximately 5% to $46.6 million during 2001 compared with revenues of $44.3 million during 2000. This increase was mainly a result of increases in sales of Privilege products (following the Preview asset acquisition) and in sales of our eToken products due to increased market penetration.

Cost of revenues. Cost of revenues primarily include the manufacturing cost of the hardware and overhead related to manufacturing activity. Cost of revenues was approximately $9.3 million during 2001 compared with $10.6 million in 2000.  Cost of revenues, as a percentage of total revenues, decreased to 20% in 2001 as compared to 24% in 2000.  This decrease was due to our producing a slightly different mix of products in 2001.  Since the cost of revenues is different for all of the products we produce, a change in the mix of products we produce in any given year will subsequently change our cost of revenues in that year.   During the year 2000, cost of revenues included, among other things, royalties that we paid to Mr. Matthias Zahn, the former principal shareholder of FAST and a former director of our company, on revenues of Hardlock products in certain countries.These royalties totaled approximately $447,000 in 2000. The payment of the royalties ceased in 2001 following an agreement with Mr. Zahn.

Research and development expenses.  Research and development expenses consist primarily of compensation and related costs of employees engaged in on going research and development activities, costs of subcontractors and related expenses. Research and development expenditures increased 27.1% to approximately $12.4 million during 2001, as compared to $9.8 million during 2000.  This increase was due to an increase in compensation expenses resulting from the hiring of new research and development personnel, primarily for the development of eToken and for our new research and development center that we opened in connection with the Preview acquisition.

Selling and Marketing expenses. Selling and marketing expenses consist primarily of compensation for sales and marketing personal, exhibitions, travel and related expenses.  Selling and marketing expenses increased to approximately $22.5 million during 2001 as compared to $20.8 million during 2000.  As a percentage of revenues, selling and marketing expenses, increased to 48.2% in 2001 from 46.8% during 2000.  This increase was a result of the implementation of our marketing plan with respect to the eSafe, eToken and Privilege product lines.

General and administrative expenses. General and administrative expenses consist primarily of compensation for finance, human resources and allowance for bad debt as well as professional service expenses. General and administrative expenses increased to approximately $7.5 million during 2001 as compared to $6.7 million during 2000.  As a percentage of revenues, general and administrative expenses, increased to 16% in 2001 from 15% during 2000.  The general and administrative expenses have been kept stable during those years.

Impairment of intangible assets. Impairment of intangible assets in 2001 consisted of the impairment of $5.2 million of the Eliashim goodwill. There was no impairment of intangible assets in 2000.

Financial income, net. Financial income (expenses) consists primarily of interest derived from cash and cash equivalents and marketable debt securities, net of bank charges and loss on decrease in value of the Company’s investment in equity securities. Financial expenses in 2001 were $(410,000) compared with financial income of $1.4 million in 2000. The decrease in the financial income was primarily due to lower interest rates on cash and cash equivalents, a reduction in cash reserves and declines in the value of the Company’s investment in equity securities. 

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Other income (expenses), net. Other income (expenses) net, was approximately $(3.4) million in 2001 compared with $5.5 million in 2000. Other income in 2001 was primarily generated by the write off of our investment in FAST Multimedia Inc. (See Item 8: “Related Party Transactions”). Other income in 2000 was primarily generated by the sale of 384,500 shares of Wave Systems Corp. Class A common stock for $4,641,225. 

Taxes on income. Taxes on income were approximately $(347,000) in 2001compared to approximately $1.6 million in 2000. Taxes on income in 2001 were primarily due to an income tax provision from ongoing operations of approximately $146,000, and deferred tax income of approximately $(493,000) from carry-forward losses. Taxes on income in 2000 were primarily due to taxes on capital gains from the sale of shares of Wave Class A common stock, which were taxed at the rate of 36% as opposed to our income from operations which is taxed at an effective rate of 8% as a result of our Approved Enterprise status.

Liquidity and Capital Resources

Since our inception, our operations have been funded through capital contributions, cash flow from operations and capital gains from sales of marketable securities.  Our business is not capital intensive.  Currently, our commitments for capital expenditures are insignificant as we lease all of our premises.

As of December 31, 2002, we had cash and cash equivalents and marketable securities aggregating approximately $15.1 million.  Our marketable securities, as of December 31, 2002, amounted to approximately $860,000. Unrealized holding gains from available-for-sale securities (which are presented as part of shareholders’ equity until realized) amounted to approximately $(67,000) thousand as of December 31, 2002.  At December 31, 2002, we had equity investments in Comsec Information Security Ltd. and Tamir Fishman Ventures II Ltd., Israeli companies publicly traded on the Tel Aviv Stock Exchange (TASE).

Our operating activities provided cash in the amount of $4.2 million in 2002 primarily due to a decrease in other accounts receivable and prepaid expenses, a decrease in inventories, a decrease in deferred income tax, equity in losses of an affiliate, impairment of investments and depreciation and amortization which was partially offset by our net operating loss. Our operating activities used cash in the amount of $5 million in 2001 primarily due to our net operating loss and a decrease in income taxes payable which was offset by an increase in accrued expenses and other liabilities, equity in losses of an affiliate, impairment of marketable securities, depreciation and amortization. Our operating activities used cash in the amount of $2.4 million in 2000. This was primarily due to gain on sale of available for sale marketable securities, an increase in inventories and an increase in other accounts receivable and prepaid expenses, that were partially offset by depreciation and amortization.

Our investing activities used cash in the amount of $2.5 million in 2002 primarily due to purchase of property and equipment, investment in and loans to affiliates. Our investing activities provided cash in the amount of $3.4 million in 2001 primarily due to proceeds from sale of available for sale marketable securities, that was offset by purchase of property and equipment, investment in affiliates and payment for the purchase of assets from Preview. Our investing activities used cash in the amount of $13.8 million in 2000 primarily due to investments in available for sale marketable securities and in Tamir Fishman II LLC and purchase of property and equipment, that were partially offset by proceeds from sale of available for sale marketable securities.

In 2002, our financing activities did not use or provide any cash. Our financing activities used cash in the amount of $0.26 million in 2001 due to purchase of treasury shares. Our financing activities provided cash in the amount of $0.16 million in 2000 primarily due to the proceeds from exercise of options, which was partially offset by purchase of treasury shares.

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We had working capital of approximately $22.7 million at December 31, 2002, $24.6 million at December 31, 2001 and $34.5 million at December 31, 2000.  Our ratio of current assets to current liabilities was 3.4 at December 31, 2002, 3.9 at December 31, 2001 and 3.7 at December 31, 2000.

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

Research and Development, Patents and Licenses, etc.

The software industry is characterized by rapid product change resulting from new technological developments, performance improvements and lower hardware costs. We believe that our future growth depends to a large extent on our ability to be an innovator in the development and application of hardware and software technology utilizing, among other things, our proprietary security algorithms. We work closely with our customers and prospective customers to determine their requirements and to design enhancements and new features to meet their needs. We intend to expand our research and development efforts, and are currently developing new products that incorporate both technology presently used in our products and technology developed for new applications.  Our research and development activities have led to periodic releases of improved versions of our HASP, HARDLOCK, Privilege and eSafe products, which offer increased functionality.  In addition, our research and development efforts have resulted in the release of eToken in June 2000.  We intend to expand our research and development efforts, and we are currently developing new products that incorporate both technology presently used in our products and technology that we are developing for new applications.

Research and development expenditures increased to approximately $13.8 million during 2002, as compared to $12.4 million during 2001 and $9.8 million during 2000.  This increase was due to an increase in compensation expenses resulting from the hiring of new research and development personnel, primarily for the development of eToken and for the research and development center, that we opened in connection with the Preview acquisition.

Trend Information

There is a trend toward integration of security software inside pre-configured, easy to install hardware appliances.  Although Aladdin has introduced its own appliance hardware integrated with eSafe Gateway and eSafe Mail, it only addresses small and medium organizations.  We are working on strategic alliances with major hardware manufacturers to introduce an appliance for the high-end of the market. In addition there is an element of service that must be provided to customers when selling hardware devices. If we are unable to correctly address the market demands for Content Security Appliances and the associated services, our competitive position, results of operations and financial condition may be adversely affected.

The Internet has become a critical tool for many companies.  The importance of the Internet, coupled with the fact that advanced technology has enabled the development of vandals and viruses that can travel over the Internet at the speed of light, causes companies to demand of us increasingly fast and effective responses to these vandals and viruses.  In order to meet this challenge, we are working on the development of enhanced versions of eSafe Gateway and eSafe Mail products. We are also continuing to invest in research and development in order to improve the quality of our products and to introduce new more effective products that will deliver more proactive solutions for blocking vandals/viruses.  The inability to develop such responses to these vandals/viruses or provide adequate service to our customers could have a material adverse effect on our business results.

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

Finally, there is a continuing worldwide slowdown in technology-based companies.  We can give no assurances that this global downturn will not affect our revenues, results of operations and the market price of our ordinary shares.

Item 6.               Directors, Senior Management and Employees
Directors and Senior Management

As of May 31, 2003, our directors, senior management and key employees are as follows:

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

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

Dr. Menahem Gutterman has been an outside director since December 31, 2000.  Dr. Gutterman has served as Executive Vice President and Head of the Operations Information Systems Division of Israeli Discount Bank Ltd since 1992.  Dr. Gutterman served as General Manager’s Assistant at Israel Discount Bank Ltd. from 1981-1992.  Prior to joining Israel Discount Bank Ltd., Dr. Gutterman served as Vice President of Sales and Services at Elscint Ltd., as well as Managing Director of Clal Systems.  Until 2000, Dr. Gutterman served as a senior lecturer at Tel Aviv University, Faculty Management, and School of Business Administration. Dr. Gutterman holds a D.Sc. in Mathematics.

Dr. Orna Berry has been an outside director since December 31, 2001.  Dr. Berry is a venture partner in Gemini Israel Funds Ltd. and the active chairperson in both Lambda Crossing, Ltd., and in Riverhead Networks, Inc. since August 2000.  Dr. Berry served as the Chief Scientist of the Ministry of Industry and Trade of the Government of Israel from 1997-2000 and co-president of ORNET Data Communications Technologies Ltd. from 1993-1997.  From 1992-1993, Dr. Berry served as a consultant to Intel Communications Division and Elbit Systems, Ltd.  Dr. Berry receiver her Ph.D. in Computer Science from the University of Southern California and M.A. and B.A. degrees in Statistics and Mathematics from Tel Aviv University and Haifa University.

Yigal Bar Yossef has served as a director since December 11, 2002. Since 2001, Mr. Yossef serves as Senior Vice President of Marketing for Amdocs Management Limited and is responsible for Amdocs’ newly acquired Clarify Division. Prior to joining Amdocs, Mr. Bar-Yossef served as Managing Director and CEO of Pelephone Communications Ltd., Israel’s pioneer cellular company, jointly owned at the time by BEZEQ. He was also the CEO of Digital from 1992 to 1997. Mr Bar Yosef holds an MBA from Hebrew University.

Dany Margalit joined our company in 1987 as Research and Development Manager and has served as a director since 1994. In 1989, Mr. Margalit was appointed Executive Vice President, Research and Development.  In 1998, he was appointed Executive Vice President, Chief Technology Officer. Mr. Margalit holds a B.Sc. in Mathematics and Computer Science from Tel Aviv University.

Erez Rosen has been Vice President for Finance and Chief Financial Officer since 1998.  In 1997, Mr. Rosen served as the head of Finance and Administration of NDS Technologies – an affiliate of News Corp. From 1994 to 1996, Mr. Rosen was employed as the Financial Controller of the Michael Levi Group, a private industrial group. From 1988 to 1994, Mr. Rosen was employed by the BASF Group in Germany, and Italy, where he served in various finance and administration positions. Mr. Rosen holds a BA in Economics from the Hebrew University in Jerusalem, an MBA from INSEAD in Fontainebleau, France and has completed the General Manager Program (TGMP) at Harvard Business School.

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Ami Dar has been President of Aladdin Knowledge Systems Inc., since October 1993.  From 1988 to 1993, Mr. Dar served as our International Marketing Manager. Ami is also the founder and chairman of Actions Without Borders.  

Steve Langerock has been Chief Executive Officer of Aladdin Knowledge Systems Inc. since 1996.  He joined Glenco in 1995 and was promoted to Chief Financial Officer and General Manager in 1996.  Prior to joining Glenco, he was Administration/Operations Manager for Advantest, a world leader in the production of semiconducter test equipment.  Mr. Langerock has extensive experience in the sales, production and financial arenas.  Mr. Langerock holds a BA in Business Management and Accounting and is a CPA and CPIM.

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

Dror Irani joined our company in 1999 as Vice President for Sales of the Internet Security Unit.  In 2000, Mr. Irani was promoted to be the Corporate Vice President Sales (for all of our product lines). In 2003 Mr. Irani took the position of Vice President, eSafe Business Unit Manager. In 1998, Mr. Irani served as the Vice President of Sales and Marketing for Perfecto Technologies, a start up in the area of Internet security. From 1993 to 1997, Mr. Irani served in several senior sales positions at Comverse Network Systems. This included 3 years at Comverse headquarters in the United States. Mr. Irani holds an MBA and an MA in Economics, as well as BSc. in Computer Science from the Hebrew University in Jerusalem.

Avishai Ziv was appointed Vice President Business Development on January 7, 2001.  Mr. Ziv previously served as Vice President of Business Development of Runway Ltd. and Managing Director of C.D.I. Systems Ltd.  Mr. Ziv also served as a management consultant to major industrial and hi-tech corporations on strategy and business development and to the Israeli Ministry of Foreign Affairs.  Mr Ziv holds a bachelors of arts degree in Political Science and Labor Studies and a masters in Labor studies from Tel Aviv University.

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

Avi Barir has been our Vice President of Software eCommerce since 2000. He is responsible for Aladdin’s Digital Rights Management (DRM) products, including HASP, Hardlock, Privilege, and the newly acquired products of Preview Systems: Ziplock and Vbox. From 1999 to 2000 Mr. Barir served as the Vice President of Marketing in BreezeCom (NASDAQ: BRZE), a company specializing in broadband wireless solutions. Between 1997 and 1999 Mr. Barir served as the Associate Vice President of Marketing in ECI Telecom’s (NASDAQ: ECIL) Access Solutions SBU. During the first 18 years of his career Mr. Barir held various research and development and sales positions in the defense industry and in the information technology industry. Mr. Barir holds a B.Sc. degree in Electronics Engineering from the Technion - Israel Institute of Technology, and a MBA degree from Tel Aviv University.

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Yanki and Dany Margalit are brothers. 

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

Compensation

During the year ended December 31, 2002, we paid in the aggregate direct remuneration to our directors and officers as a group who served in the capacity of director or executive officer during such year (not including our subsidiaries), approximately $1,275,758. This amount includes directors’ fees and expenses, but does not include amounts expended by us for automobiles made available to our officers, expenses (including business travel, professional and business association dues and expenses) reimbursed to officers and other fringe benefits commonly reimbursed or paid by companies in Israel.  In addition, we set aside or accrued approximately $160,749 to provide pension, retirement or similar benefits. 

Certain of the compensation paid to our directors in 2002 is paid in the form of options under our Aladdin Knowledge Systems Ltd. 2001 Israeli Share Option Plan.  This Plan is described in full under “Employee Share Option Plans” below.   In 2002, we granted options to purchase 2,500 ordinary shares under the 2002 Plan to each of Mr. Assia, Dr. Gutterman and Dr. Berry.  The exercise price of the options was $1.20 and they vest in various portions over the course of the 12 to 48 months from the date of grant.

Board Practices

          Board of Directors

Although our shareholders are free to determine the size of our board, until such a determination is made, our Articles of Association provide for a board of directors of not less than two, and not more than eight members. Each director, with the exception of outside directors who are elected to serve set periods of time as described below, is elected to serve until the next annual general meeting of shareholders and until his successor has been elected. Officers serve at the discretion of the board of directors.

Substitute Directors

Our Articles of Association provide that any director may, by written notice to us, appoint another person to serve as a substitute director and may cancel such appointment. A person may not serve as a substitute director for more than one director and may not serve as both director and as a substitute director. 

The term of appointment of a substitute director may be for one meeting of the board of directors or for a specified period or until notice is given of the cancellation of the appointment.  To our knowledge, no director currently intends to appoint any other person as a substitute director, except if the director is unable to attend a meeting of the board of directors.

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Outside Directors

The Israeli Companies Law (the “Companies Law”), requires Israeli companies with shares that have been offered to the public in or outside of Israel to appoint two outside directors.  Dr. Gutterman was elected as an outside director at our Annual Meeting of Shareholders on December 31, 2000 and Dr. Orna Berry was elected as an outside director at our Annual Meeting of Shareholders on December 31, 2001.

No person may be appointed as an outside director if the person or the person’s relative, partner, employer or any entity under the person’s control, has or had, on or within the two years preceding the date of the person’s appointment to serve as outside director, any affiliation with the company or any entity controlling, controlled by or under common control with the company.  The term “affiliation” includes:

No person may serve as an outside director if the person’s position or other business activities create, or may create, a conflict of interest with the person’s responsibilities as an outside director or may otherwise interfere with the person’s ability to serve as an outside director.  If, at the time outside directors are to be appointed, all current members of the board of directors are of the same gender, then at least one outside director must be of the other gender.

Outside directors are to be elected by a majority vote at a shareholders’ meeting, provided that either:

The initial term of an outside director is three years and may be extended for an additional three years.  Outside directors may be removed only by the same percentage of shareholders as is required for their election, or by a court, and then only if the outside directors cease to meet the statutory qualifications for their appointment or if they violate their duty of loyalty to the company.  Each committee of a company’s board of directors must include at least one outside director.  

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An outside director is entitled to compensation as provided in regulations adopted under the Companies Law and is otherwise prohibited from receiving any other compensation, directly or indirectly, in connection with service provided as an outside director.

In addition, pursuant to the listing requirements of the NASDAQ National Market, we are required to have at least two independent directors on our board of directors.  Dr.  Gutterman and Dr. Orna Berry qualify as independent directors under the NASDAQ National Market requirements.

Audit Committee

The Companies Law requires public companies to appoint an audit committee.  The responsibilities of the audit committee include identifying irregularities in the management of the company’s business and approving related party transactions as required by law.  An audit committee must consist of at least three directors, including the outside directors of the company.  The chairman of the board of directors, any director employed by or otherwise providing services to the company, and a controlling shareholder or any relative of a controlling shareholder, may not be a member of the audit committee. 

We are also required by the NASDAQ National Market to establish an audit committee, at least a majority of whose members is independent of management. Mr. Assia, Dr. Gutterman and Dr. Berry serve as members of our audit committee.  Dr. Gutterman and Dr. Berry, our independent directors, both serve on the audit committee. 

Internal Auditor

Under the Companies Law, the board of directors must appoint an internal auditor, nominated by the audit committee.  The role of the internal auditor is to examine, among other matters, whether the company’s actions comply with the law and orderly business procedure.  Under the Companies Law, the internal auditor may be an employee of the company but not an office holder, or an affiliate, or a relative of an office holder or affiliate, and he may not be the company’s independent accountant or its representative.

Employees

The following table sets forth for the last three fiscal years, the number of our employees engaged in the specified activities:

*Includes employees for product lines acquired in the Preview acquisition.

Over the last three years, we have continued investing in research and development by increasing the number of staff working in that department.

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

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

A general practice followed by us, although not legally required, is the contribution of funds on behalf of most of our employees to a fund known as “Managers’ Insurance.” This fund provides a combination of savings plan, insurance and severance pay benefits to the employee, giving the employee payments upon retirement or death and securing the severance pay, if legally entitled, upon termination of employment. We decide whether each employee is entitled to participate in the plan, and each employee who agrees to participate contributes an amount equal to 5% of his salary towards savings and the employer contributes 8.33% for severance payments, 5% of his/her salary towards savings and up to 2.5% for disability.

Our success has been, and will be, dependent to a large degree on our ability to retain the services of key personnel and to attract additional qualified personnel in the future.  Competition for such personnel is intense.  There can be no assurance that we will be able to attract, assimilate or retain key personnel in the future and the failure to do so would have a material adverse effect on our business, financial condition and results of operations.

Employee Share Option Plans

We maintain the following share option plans for our and our subsidiaries’ employees, directors and consultants.  In addition to the discussion below, see Note 14d. to our Consolidated Financial Statements.

In 2002, our board of directors adopted the 2002 Israeli Share Option Plan pursuant to which 250,000 ordinary shares were reserved for issuance upon the exercise of options granted to our (including our subsidiaries) employees, directors, consultants and service providers.  As of May 31, 2003, options to purchase 235,500 of such ordinary shares at an exercise price per share of $1.20 were outstanding and options to purchase 14,500 ordinary shares were available for future grants.  The exercise prices of options granted under the plan are the market price of the ordinary shares on the date of grant.   Under the 2002 Plan, options terminate ten years following the date of grant if not exercised earlier.  None of the outstanding options are vested.  The non-vested options referred to above vest between October 24, 2003 and October 24, 2006.  The options are not assignable except by the laws of descent.

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In 2001, our board of directors adopted the 2001 Israeli Share Option Plan pursuant to which 400,000 ordinary shares were reserved for issuance upon the exercise of options granted to our (including our subsidiaries) employees, directors, consultants and service providers.  As of May 31, 2003, options to purchase 299,800 of such ordinary shares at exercise prices per share ranging from $1.20 to $3.50 were outstanding and options to purchase 100,200 ordinary shares were available for future grants.  The exercise prices of options granted under the plan are the market price of the ordinary shares on the date of grant.   Under the 2001 Plan, options terminate ten years following the date of grant if not exercised earlier.  Of the outstanding options 75,800 are fully vested.  The non-vested options referred to above vest between October 24, 2003 and October 24, 2006.  The options are not assignable except by the laws of descent.

On October 25, 2000, our board of directors adopted the 2000 Israeli Share Option Plan pursuant to which 500,000 ordinary shares were reserved for issuance upon the exercise of options granted to our (including our subsidiaries) employees, directors, consultants and service providers.  The options granted under this plan may or may not qualify for special tax treatment under Section 102 of the Israeli Income Tax Ordinance (New Version) 1961.  As of May 31, 2003, options to purchase 430,000 of such ordinary shares at exercise prices per share ranging from $1.20 to $4.50 were outstanding and options to purchase 70,000 ordinary shares were available for future grants.  The exercise prices of options granted under the plan are the market price of the ordinary shares on the date of grant.   Under the 2000 Plan, options terminate ten years following the date of grant if not exercised earlier.  207,942 of the outstanding options are fully vested.  The remaining options vest between October 24, 2003 and October 24, 2006.  The options are not assignable except by the laws of descent.

In 1999, our board of directors adopted the 1999 Israeli Share Option Plan pursuant to which 250,000 ordinary shares were reserved for issuance upon the exercise of options granted to our (including our subsidiaries) employees, directors, consultants and service providers.  As of May 31, 2003, options to purchase 249,050 of such ordinary shares at exercise prices per share ranging from $1.20 to $7.50 were outstanding and options to purchase 950 ordinary shares were available for future grants.  154,175 of the outstanding options are fully vested. The remaining options will vest between October 24, 2003 and October 24, 2006.  The terms of these options are substantially similar to those of the 2000 Israeli share option plan.

In 1998, our board of directors adopted the 1998 Israeli Share Option Plan pursuant to which 250,000 ordinary shares were reserved for issuance upon the exercise of options granted to our (including our subsidiaries) employees, directors, consultants and service providers.  As of May 31, 2003, options to purchase 235,100 of such ordinary shares were outstanding and options to purchase 14,900 ordinary shares were available for future grants.  Of the outstanding options (i) options to purchase 115,150 ordinary shares are fully vested and are exercisable at exercise prices ranging from $4.50 to $8.50 per share and (ii) options to purchase 119,950 ordinary shares are not vested and are exercisable at $1.20 - $8.50 per share.  The options referred to in (ii) above will vest between October 24, 2003 and October 24, 2006.  The terms of these options are substantially similar to those of the 2000 and 1999 Israeli share option plans.

In addition, there are 258,550 outstanding options that were granted to our employees under option plans between the years 1993 and 1997.

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Share Ownership

All of the persons listed above, under the caption “Directors, Senior Management and Employees” who are employed by us own shares and/or options to purchase ordinary shares.  Except as set forth below, none of the named directors or employees owns shares and/or options amounting to 1% or more of our outstanding ordinary shares.  Yanki Margalit owns 2,149,689 ordinary shares which is 18.7% of our outstanding capital.  Danny Margalit owns 1,269,195 ordinary shares which is 11.1% of our outstanding capital. 

Item 7.               Major Shareholders and Related Party Transactions