Wave Systems 10Q 2006 Q2 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2006

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

For the transition period from to

Commission File Number 0-24752

Wave Systems Corp.

(Exact name of registrant as specified in its charter)

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

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

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

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

Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer x

Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

The number of shares outstanding of each of the issuer’s classes of common stock as of August 7, 2006: 38,622,029 shares of Class A Common Stock and 41,908 shares of Class B Common Stock.

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Balance Sheets

(Unaudited)

	As of
	June 30, 2006			December 31, 2005
Assets
Current assets:
Cash and cash equivalents	$	1,891,166		$	2,006,022
Accounts receivable, net of allowance for doubtful accounts of $54,578 and $14,087 at June 30, 2006 and December 31, 2005, respectively	881,223			334,659
Prepaid expenses	199,600			139,686
Total current assets	2,971,989			2,480,367
Property and equipment, net	609,078			754,153
Other assets	134,267			195,245
Total assets	3,715,334			3,429,765
Liabilities and Stockholders’ Equity (Deficiency)
Current liabilities:
Accounts payable and accrued expenses	2,526,377			3,089,150
Deferred revenue	564,163			503,630
Total current liabilities	3,090,540			3,592,780

Liability for warrants containing cash settlement provisions	—			2,794
Total liabilities	3,090,540			3,595,574

Common stock, $.01 par value. Authorized 150,000,000 shares as Class A; 36,285,277 shares issued and outstanding in 2006 and 31,113,918 in 2005	362,852			311,139
Common stock, $.01 par value. Authorized 13,000,000 shares as Class B; 41,908 shares issued and outstanding in 2006 and 58,575 in 2005	419			586
Capital in excess of par value	294,539,363			284,269,292
Accumulated deficit	(294,277,840		)	(284,746,826		)
Total Stockholders’ Equity (Deficiency)	624,794			(165,809		)
Total Liabilities and Stockholders’ Equity (Deficiency)	$	3,715,334		$	3,429,765

See accompanying notes to unaudited consolidated financial statements.

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Statements of Operations

(Unaudited)

	Three months ended						Six months ended
	June 30, 2006			June 30, 2005			June 30, 2006			June 30, 2005
Net Revenues:
Licensing	$	682,645		$	244,130		$	991,047		$	315,149
Services	227,800			13,525			412,512			20,382
Total Net Revenues	910,445			257,655			1,403,559			335,531
Cost of sales:
Licensing	87,077			6,943			99,248			11,569
Services	169,659			14,586			275,304			23,723
Amortization expense	99,106			155,355			196,367			310,710
Total Cost of sales	355,842			176,884			570,919			346,002
Gross profit	554,603			80,771			832,640			(10,471		)
Operating expenses:
Selling, general, and administrative	3,211,845			2,937,271			6,402,259			5,933,862
Research and development	1,912,122			1,669,644			4,012,500			3,264,102
	5,123,967			4,606,915			10,414,759			9,197,964
Other income (expense):
Interest income	30,256			18,934			48,311			40,070
Unrealized (loss) gain in value of warrant liability	—			347,285			2,794			462,860
	30,256			366,219			51,105			502,930
Net loss	(4,539,108		)	(4,159,925		)	(9,531,014		)	(8,705,505		)
Loss per common share	$	(0.13	)	$	(0.15	)	$	(0.28	)	$	(0.33	)
Weighted average number of common shares outstanding during the period	35,416,469			27,041,998			33,998,077			26,393,208

See accompanying notes to unaudited consolidated financial statements.

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

	Six Months ended
	June 30, 2006			June 30, 2005
Cash flows from operating activities:
Net loss	$	(9,531,014	)	$	(8,705,505	)
Depreciation and amortization	323,503			413,636
Non-Cash expenses:
Unrealized gain on decrease in value of warrant liability	(2,794		)	(462,860		)
Compensation associated with issuance of stock options	760,575			3,647
Changes in assets and liabilities:
Increase (decrease) in deferred revenue	60,533			123,390
Increase in prepaid expenses and accounts receivables	(606,478		)	(160,787		)
Increase (decrease) in other assets	60,978			7,051
Increase (decrease) in accounts payable and accrued expenses	(562,776		)	25,670
Net cash used in operating activities	(9,497,470		)	(8,755,758		)

Cash flows from investing activities:
Acquisition of property and equipment	(178,428		)	(50,811		)
Net cash used in investing activities	(178,428		)	(50,811		)

Cash flows from financing activities:
Net proceeds from issuance of common stock	9,561,042			4,083,713
Net cash provided by financing activities	9,561,042			4,083,713

Net increase (decrease) in cash and cash equivalents	(114,856		)	(4,722,856		)

Cash and cash equivalents at beginning of period	2,006,022			5,805,912

Cash and cash equivalents at end of period	$	1,891,166		$	1,083,056

See accompanying notes to unaudited consolidated financial statements.

WAVE SYSTEMS CORP. AND SUBSIDIARIES

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

(Unaudited)

	Class A Common Stock			Class B Common Stock					Capital in excess		Accumulated
	Shares	Amount		Shares		Amount			of Par Value		Deficit			Total
Balance at December 31, 2005	31,113,918	$	311,139	58,575		$	586		$	284,269,292	$	(284,746,826	)	$	(165,809	)

Net Income (Loss) and comprehensive loss	—	—		—		—			—		(9,531,014		)	(9,531,014		)

Issuance of Class A Common Stock at $1.605 per share, net of issuance costs of $216,289	2,782,866	27,828		—		—			4,222,383		—			4,250,211

Issuance of Class A Common Stock at $2.40 per share, net of issuance costs of $281,561	2,012,500	20,125		—		—			4,528,314		—			4,548,439

Warrants exercised at $2.16 per share net of issuance costs of $14,000	162,037	1,620		—		—			334,380		—			336,000

Warrants exercised at $2.40 per share net of issuance costs of $11,000	114,583	1,146		—		—			262,853		—			263,999

Shares of Class A Common Stock issued pursuant to the Wave Employee Stock Purchase Plan at $1.9635	82,706	827		—		—			161,566		—			162,393

Exchange of Class B Common Stock for Class A Common Stock	16,667	167		(16,667	)	(167		)	—		—			—

Compensation cost for stock options granted to employees	—	—		—		—			760,575					760,575

Balance at June 30, 2006	36,285,277	$	362,852	41,908		$	419		$	294,539,363	$	(294,277,840	)	$	624,794

See accompanying notes to unaudited consolidated financial statements.

WAVE SYSTEMS CORP. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements

June 30, 2006 and 2005

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the financial position of Wave Systems Corp. as of June 30, 2006 and December 31, 2005, and the results of its operations and cash flows for the three-month and six-month periods ended June 30, 2006 and 2005. Such financial statements have been prepared in accordance with the applicable regulations of the Securities and Exchange Commission (the “Commission”).

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. It is suggested that these consolidated financial statements be read in conjunction with Wave’s audited financial statements and notes thereto for the year ended December 31, 2005, included in its Form 10-K filed on March 9, 2006. The results of operations for the three-month and six-month periods ended June 30, 2006 are not necessarily indicative of the operating results for the full year or any future periods.

The consolidated financial statements of Wave include the financial statements of Wave Systems Corp.; Wave Systems Holdings, Inc., a wholly-owned subsidiary; and Wavexpress, Inc., a joint venture between Wave and Sarnoff Corporation. All significant intercompany transactions have been eliminated. Prior to January 1, 2006, the financial statements of Wave were presented in the development stage format as prescribed by Statement of Financial Accounting Standards No. 7 – “Accounting and Reporting by Development Stage Enterprises.”

On July 24, 2006, our Board of Directors approved a reverse stock split of our common stock at a ratio of one-for-three, causing each three outstanding shares of Class A common stock and Class B common stock to convert automatically into one share of Class A common stock or Class B common stock, respectively. The par value of Class A common stock and Class B common stock remains $0.01 per share. The reverse split became effective at the close of business on July 25, 2006. In lieu of fractional shares, stockholders will receive a cash payment based on an average trading price of the Class A common stock prior to the effectiveness of the reverse split. Stockholders’ equity has been restated to give retroactive recognition to the reverse split for all periods presented by reclassifying the excess par value resulting from the reduced number of shares from common stock to paid-in capital. Except as otherwise noted, all references to common share and per common share amounts (including warrant shares, shares reserved for issuance and applicable exercise prices) for all periods presented have been retroactively restated to reflect this reverse split.

1. Liquidity

The accompanying consolidated financial statements have been prepared assuming that Wave will continue as a going concern. Wave has substantial operating losses since its inception, and as of June 30, 2006, has an accumulated deficit of $294,277,840. We also expect Wave will incur an operating loss for the calendar year 2006. As of June 30, 2006, we had negative working capital of $118,551.

Wave has begun market introduction of its security and broadband media distribution software products and has signed initial distribution contracts for these applications. However, due to the early stage nature of this market, it is unlikely that Wave will generate sufficient revenue to cover all of its cash flow needs to fund its operating requirements for the twelve months ending June 30, 2007.

Because Wave does not have sufficient cash to fund operations for the twelve months ending June 30, 2007; and given the uncertainties described above with respect to Wave’s revenue outlook for 2006, Wave has been and will continue to be actively engaged in financing activities in order to generate

additional funding to cover its operating costs. These activities include the filing of a $25,000,000 S-3 shelf registration with the SEC on December 16, 2005 which was declared effective on January 31, 2006; and the sale of 2,782,866 shares of common stock at $1.605 per share for gross proceeds of $4,466,500 in an initial round of financing under this shelf registration on February 15, 2006, for which we received approximately $4,250,000 in net proceeds. We also granted warrants as part of the February 15 financing that allowed the purchasers to acquire an additional 516,956 shares of Wave common stock for $2.16 per share. On May 8, 2006 an investor exercised one of these warrants for 162,037 shares, at an exercise price of $2.16 per share. Wave received $336,000 from this warrant exercise after subtracting the 4% placement agent fee. The warrants that remain outstanding expire on August 15, 2006. Pursuant to a financing entered into on May 3, 2006 under the same shelf registration statement, we also sold 2,012,500 shares of Wave’s Class A common stock at $2.40 per share for gross proceeds of $4,830,000, for which we received approximately $4,548,400 in net proceeds. In connection with that financing, we also agreed to issue a warrant to the placement agent (as part of the fees paid to the placement agent) that will allow the placement agent to acquire 100,625 shares of Wave Class A common stock for $2.40 per share. The warrant expires on June 3, 2007.

On May 8, 2006, an investor also exercised a warrant issued by Wave to that investor in connection with Wave’s December 5, 2005 financing. The warrant was exercised in full for 114,583 shares of Wave Class A Common Stock, at an exercise price of $2.40 per share. Wave received $264,000 from the exercise of this warrant after subtracting the 4% placement agent fee.

Also, pursuant to a financing entered into on August 4, 2006 under the same shelf registration statement, we sold 2,336,752 shares of Wave’s Class A common stock at $2.05 per share for gross proceeds of $4,790,342, for which we expect to receive approximately $4,520,800 in net proceeds. In connection with that financing, we also agreed to issue a warrant to the placement agent (as part of the fees paid to the placement agent) that will allow the placement agent to acquire 116,837 shares of Wave Class A common stock for $2.05 per share. The warrant expires on September 3, 2007.

It is likely that we will be required to sell additional shares of common stock, preferred stock, obtain debt financing or engage in a combination of these financing alternatives, utilizing this shelf registration, to raise additional capital to continue to fund our operations for the twelve months ending June 30, 2007. The remaining availability under this shelf registration statement for future financings, after subtracting the proceeds from the February 15, 2006, May 3, 2006 and August 4, 2006 financings referred to above is $10,563,000 including $1,248,000 reserved for warrants to purchase 572,381 shares of Class A Common Stock, that expire beginning on August 15, 2006 through September 4, 2007.

Also, previously, on April 15, 2004 Wave filed a $25,000,000 registration statement with the SEC, under which Wave has drawn down a total of $22,494,000 in gross proceeds, through various sales of common stock. There remains approximately $2,506,000 in gross proceeds available under the April 15, 2004 shelf registration statement.

The combined remaining availability under the two shelf registration statements, for future financings, totals $13,069,000, of which $1,248,000 is reserved for outstanding warrants. The availability and amount of any such financings are unknown at this time.

Considering our current cash balance, including the additional capital raised on August 4, 2006, we project that we have enough liquid assets to continue operating into November 2006. We estimate we will need a minimum of approximately $10.6 million of additional cash, over and above the funds received from the August 4, 2006 financing, from a combination of revenue growth and additional financings, to fund operating expenses and capital expenditures for the twelve months ending June 30, 2007.

If Wave is not successful in raising the needed capital referred to above, or is not successful in executing its business plan, we could be forced to cease operations or merge with another company. No assurance can be provided that any of these initiatives will be successful. Due to our current cash position, our capital needs over the next year and beyond, the fact that we have not at this time secured enough financing to fund our operations through June 30, 2007 and beyond, and the uncertainty as to

whether we will achieve our sales forecast for our products and services, substantial doubt exists with respect to our ability to continue as a going concern.

2. Loss per Share

Basic net loss per common share has been calculated based upon the weighted average number of shares of common stock outstanding during the period. Diluted net loss per share is also computed using the weighted average number of common shares and excludes dilutive potential common shares outstanding, as their effect is anti-dilutive. Dilutive potential common shares consist primarily of employee stock options and stock warrants. Diluted net loss per share is equal to basic net loss per share and is therefore not presented separately in the financial statements. The weighted average number of potential common shares that would have been included in diluted loss per share, had their effect not been anti-dilutive for each of the three-month and six-month periods ended June 30, 2006, were approximately 173,000 shares and 89,000 shares, respectively versus 15,000 shares and 74,000 shares for the three-month and six-month periods ended June 30, 2005, respectively. Employee stock options and other stock warrants to purchase a weighted average of approximately 5,849,140 and 5,628,000 shares were outstanding for the three-month and six month period ended June 30, 2006, respectively versus 5,980,000 and 5,865,000 shares of the three-month and six-month periods ended June 30, 2005, respectively, but would not have been included in the computation of diluted loss per share because their exercise price was greater than the average share price of Wave’s common shares and, therefore, their effect would have been anti-dilutive.

3. Wavexpress

In April 1999, Wave joined with Sarnoff Corporation to form Wavexpress. Wavexpress develops secure broadband media distribution software products, infrastructure and content services. On October 15, 1999, Wave and Sarnoff signed a Joint Venture Agreement, which formally established Wavexpress. Under this agreement, Sarnoff and its affiliates received a 40% equity stake in Wavexpress. Wave received a 53% equity interest, and its affiliates, who purchased founders stock in April 1999 for a nominal amount, owned the remaining 7% of the outstanding capital stock. The affiliates of Wave include Peter Sprague, the former Chairman of Wave and Steven Sprague, the Chief Executive Officer of Wave, certain members of the Board of Directors of Wave and certain Wave employees.

Wave has funded Wavexpress through a series of convertible notes, some with attached warrants. The notes bear interest at the rate of 2% to 3% above the Prime Rate of Chase Manhattan Bank. Generally, the notes are convertible into shares of common stock of Wavexpress at varying prices per share. Through June 30, 2006, Wave has funded Wavexpress with approximately $39.2 million in cash, plus approximately $13.3 million in accrued interest. Such amounts include approximately $9.5 million that automatically converted into 1,826,570 additional shares of Wavexpress at an average conversion price of $5.20 per share. These amounts are eliminated in consolidation.

As of June 30, 2006, Wave owned 69% of Wavexpress, while Sarnoff owned 25.6%. None of the minority shareholders have provided, or are obligated to provide, funding to Wavexpress. Accordingly, the financial statements of Wavexpress have been included in the consolidated financial statements of Wave for all periods presented herein. In addition, Wave has not recorded a minority interest in Wavexpress in the consolidated financial statements and therefore has reflected 100% of Wavexpress’ balance sheet and operating results in its consolidated financial statements. Wavexpress’ net losses included in Wave’s consolidated financial statements were approximately $593,000 and $546,000 for the three-month periods ended June 30, 2006 and June 30, 2005, respectively, and $1,194,000 versus $1,146,000 for the six-month periods ended June 30, 2006 and 2005, respectively.

4. Share-based Compensation

In January 1994, Wave adopted the 1994 Employee Stock Option Plan (the “1994 Plan”). The total number of shares of Class A Common Stock reserved for issuance under the 1994 Plan, as amended is

6,833,333 shares. The 1994 Plan Expires on January 1, 2009. In September 1996, Wave adopted the 1996 Performance Stock Option Plan (the “1996 Plan”). The number of shares of Class A Common Stock subject to the 1996 Plan was 266,666. Under 1994 and 1996 Plans, both incentive stock options and non-qualified stock options may be granted to officers, key employees and other persons providing services to Wave. Options granted under the plans generally vest over three years and expire ten years from the date of grant. In January 1994, Wave adopted the Non-Employee Directors Stock Option Plan (the “Directors’ Plan”). The total number of shares of Class A Common Stock reserved for issuance under the Directors’ Plan, as amended is 333,333 shares. Under the Directors’ Plan, each director who is not an employee of Wave receives an initial grant of options to purchase 4,000 shares of Class A Common Stock; and an additional annual grant to purchase 3,333 shares on the day immediately following each of the dates on which an incumbent director is reelected. The options granted to non-employee directors vest on the day following the grant and expire ten years from the date of grant. Under all of Wave’s stock option plans, options are granted with exercise prices that approximate fair market value at the date of grant. All of Wave’s stock option plans and amendments thereto have been approved by shareholder vote.

In November 2004 Wave adopted the 2004 Employee Stock Purchase Plan (the “Purchase Plan”) pursuant to which a total of 1,000,000 shares of Wave’s Common Stock may be sold to eligible employees at a 15% discount from the market value of the shares. The Purchase Plan was approved by a vote of Wave’s shareholders. Under the terms of the Purchase Plan, employees may elect to have withheld, up to 15% of their base earnings to purchase these shares during each offering period, up to a maximum of $25,000 in market value of Wave Common Stock. Offering periods commence on May 1st and December 1st and are for a period of six months. The purchase price under the Purchase Plan is 85% of the lesser of the market price on the beginning or the ending of the offering period.

On January 1, 2006, Wave adopted Statement of Financial Accounting Standards No. 123 (R), “Share-Based Payment,” (“SFAS No. 123(R)”) which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options and employee stock purchases based on estimated fair values. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS No. 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

SFAS No. 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s consolidated statement of operations. SFAS No. 123(R) supersedes Wave’s previous accounting under the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” As permitted by SFAS No. 123 Wave measured compensation cost for options granted prior to January 1, 2006, in accordance with Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees” and related interpretations. Accordingly, no accounting recognition was given to stock options granted at fair market value until they were exercised. Upon exercise, net proceeds, including tax benefits realized, were credited to equity.

Wave adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006. In accordance with the modified prospective transition method, Wave’s consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). Stock-based compensation expense recognized under SFAS No. 123(R) for the three-month and six-month periods ended June 30, 2006 was $407,838 and $760,575 respectively. There was no stock-based compensation expense recognized during the three-month and six-month periods ended June 30, 2005. The following table summarizes share based compensation in accordance with SFAS 123(R) for the three-month and six-month periods ended June 30, 2006:

	Three months ended June 30, 2006		Six months ended June 30, 2006
Cost of Sales	$	13,302	$	17,142
Selling, General & Administrative	276,309		533,331
Research & Development	118,227		210,102
Total	$	407,838	$	760,575

Wave uses the Black-Scholes-Merton option pricing model to value stock options. The Black-Scholes-Merton model requires the use of employee exercise behavior data and the use of a number of assumptions including volatility of the company’s stock price, the weighted average risk-free interest rate, and the weighted average expected term of the options. As Wave does not pay dividends, the dividend rate variable in the Black-Scholes-Merton model is zero. The following values for the indicated variables were used to value options granted during the three-month and six-month periods ended June 30, 2006; and we expect the assumptions used for grants in future quarters of fiscal 2006 to approximate these values.

	Quarter ended June 30, 2006
Expected Term (in years)	5 Years
Risk-free Rate	4.765% - 5.105	%
Expected Volatility	99.3	%
Dividend Yield	0.0	%

The volatility assumption is based on the historical weekly price data of Wave’s stock over a period equivalent to the weighted average expected term of the options. Management did not identify any factors during that period which were unusual and which would distort the volatility figure if used to estimate future volatility.

The risk-free interest rate assumption is based upon the implied yield available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term of the option granted.

The expected term of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding. It is based upon an analysis of the historical behavior of option holders during the period from January 1, 2000 to December 31, 2005. Management believes historical data is representative of future exercise behavior.

As stock-based compensation expense recognized in the consolidated statement of operations pursuant to SFAS No. 123(R) is based on awards ultimately expected to vest, expense for grants beginning upon adoption of SFAS No. 123(R) on January 1, 2006 is reduced for estimated forfeitures. The estimated forfeiture rate used in the calculation of share-based compensation expense was approximately 20.95% for the three-month and six-month periods ended June 30, 2006. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.

A summary of option activity for all Wave option plans through June 30, 2006 follows:

	Number of Shares		Weighted Average Exercise Price
Outstanding as of December 31, 2005	4,122,870		$	11.4723
Granted	932,533		1.8891
Canceled	(270,729	)	19.8759
Balance as of June 30, 2006	4,784,674		9.129
Remaining contractual term – options outstanding	6.3 Years

Exercisable as of June 30, 2006	3,119,821		$	12.6429
Remaining contractual term – options exercisable	4.8 Years

The weighted average grant date fair value of options granted in the three-month and six-month periods ended June 30, 2006 was $1.41 and $1.44 per share, respectively.

As of June 30, 2006, unrecognized stock based compensation related to stock options was approximately $1.6 million. This cost is expected to be expensed over the three year period ended June 30, 2009. The total fair value of shares that vested during the three-month and six-month periods ended June 30, 2006 was approximately $14,000 and $1,103,000 respectively.

Pro forma Information under SFAS No.123

The following table shows the pro forma effect on net loss and net loss per share if Wave had applied the fair value recognition provisions of SFAS 123 to stock-based employee awards.

	For the quarter ended June 30, 2005			For the six months Ended June 30, 2005
Net loss to common shareholders – as reported	$	(4,159,925	)	$	(8,705,505	)
Fair value compensation cost under SFAS 123	(474,420		)	(1,066,341		)
Net loss to common shareholders – pro forma	(4,634,345		)	(9,771,846		)
Loss per common share – as reported	(0.15		)	(0.33		)
Loss per common share – pro forma	$	(0.17	)	$	(0.37	)

The following values for the indicated variables were used to value options granted during the quarter ended June 30, 2005.

Expected Term (in years)	5 Years
Risk-free Rate	3.57	%
Expected Volatility	108.8	%
Dividend Yield	0.0	%

5. Warrants Containing Cash Settlement Provisions

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

On November 18, 2003, Wave granted warrants to purchase 310,436 shares of Wave common stock at an exercise price of $7.86 per share in connection with a private placement of common stock with a group of accredited investors. The warrants have a three-year term. The contract underlying the warrants includes a provision that would require Wave to pay liquidated damages in cash to the warrant holders if at any time the warrants are “in the money” and the registration statement underlying such shares ceases to remain continuously effective. Because of this provision, the contract is considered to contain a net cash settlement provision as defined in EITF 00-19. Although the registration statement was declared effective by the Securities Exchange Commission on February 12, 2004, the net cash settlement provision still applies because of the stipulation that it must remain continuously effective and because there are circumstances that could potentially cause the registration statement to cease to remain effective. Accordingly, Wave recorded a liability in its balance sheet that was valued at $0 as of June 30, 2006 and $2,794 as of December 31, 2005. These values were determined utilizing the Black-Scholes option pricing model with the following assumptions:

	As of June 30, 2006		As of December 31, 2005
Expected life (years)	0.40		0.90
Interest rate	5.15	%	4.36	%
Volatility	61	%	62	%
Dividend yield	0	%	0	%

The decrease in fair value of the liability associated with the warrants of $2,794 was recorded as an unrealized gain in Wave’s statement of operations in the six-month period ended June 30, 2006, versus a gain of $462,860 that was recorded for the six-month period ended June 30, 2005, in accordance with EITF 00-19.

6. Contingencies

Securities and Exchange Commission Investigation

On December 17, 2003, Wave received an Order by the Securities and Exchange Commission (the “Commission”) regarding a formal investigation. The focus of this investigation is on certain public statements made by Wave during and around August 2003, as well as certain trading in Wave’s securities during such time. Wave is cooperating fully with the Commission in this investigation. Wave is unable to predict the outcome of this investigation at this time.

Purported Class Actions

A consolidated amended class action complaint is pending in the United States District Court for the District of Massachusetts, naming Wave, its Chief Executive Officer and its Chief Financial Officer as defendants. Brumbaugh et al. v. Wave Systems Corp. et al., Civ. No. 04-30022 (D. Mass.) (MAP).

The purported class action has been filed by alleged purchasers of Wave’s Class A Common Stock during the purported class period July 31, 2003 through February 2, 2004. The complaint claims that Wave and the named individuals violated Section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”), Rule 10(b)-5 promulgated thereunder and Section 20(a) of the 1934 Act by publicly disseminating materially false and misleading statements, relating to Wave’s agreements with Intel and IBM. The complaint does not specify the amount of alleged damages plaintiffs seek to recover.

In January 2006, the Court granted in part and denied in part defendants’ motion to dismiss. The Court dismissed two but let stand seven alleged misrepresentations or omissions. This is not a finding of fault or liability, it is a decision not entirely to dismiss plaintiffs’ pleading.

Without admitting liability, the defendants recently reached a mediated settlement in principle of all claims asserted by the plaintiffs. The settlement must be approved by the Court before it is final. Wave’s insurer has agreed to pay the plaintiffs a total of $1,750,000 in exchange for the dismissal with prejudice and release of the claims against all defendants. The settlement in principle is also subject to drafting and execution of formal settlement agreements.

Derivative Demand Letter

Previously, a purported shareholder derivative action was filed in the United States District Court for the District of Massachusetts. The case was dismissed by the District Court, and on April 25, 2006, an appeal filed by the plaintiff was voluntarily dismissed, with prejudice.

On May 17, 2006, one of the named plaintiffs in the dismissed derivative action sent a shareholder demand letter to our board of directors. The shareholder demands that we initiate litigation against the same defendants named in, and asserting the same claims as made in, the dismissed derivative litigation. The board has taken the matter under advisement. An adverse resolution of the shareholder derivative demand letter may have a negative effect on our financial condition and operating results.

7. Segment Reporting

Wave’s products include the Wave EMBASSY^® digital security products and services and Wavexpress broadband media distribution products and services. These products and services constitute Wave’s

reportable segments under “Statement of Financial Accounting Standard No. 131 ― Disclosures about Segments of an Enterprise and Related Information. Net losses for reportable segments exclude interest, and gain on decrease in value of warrant liability. These items are not reported by segment since they are excluded from the measurement of segment performance reviewed by Wave’s management.

The following sets forth reportable segment data:

	Three months ended June 30,						Six months ended June 30,
	2006			2005			2006			2005
Operating Revenues:
EMBASSY® digital security products and services	$	902,774		$	248,795		$	1,383,565		$	318,272
Wavexpress broadband media distribution products and services	7,671			8,860			19,994			17,259
Total Operating Revenues	910,445			257,655			1,403,559			335,531
Net Loss:
EMBASSY® digital security products and services	(3,975,186		)	(3,980,477		)	(8,387,802		)	(8,062,413		)
Wavexpress broadband media distribution	(594,177		)	(545,667		)	(1,194,316		)	(1,146,022		)
Total Segments Net Loss	(4,569,363		)	(4,526,144		)	(9,582,118		)	(9,208,435		)
Interest income	30,256			18,934			48,310			40,070
Unrealized gain (loss) on change in value of warrant liability	—			347,285			2,794			462,860
Net Loss	(4,539,108		)	(4,159,925		)	(9,531,014		)	(8,705,505		)
Depreciation and Amortization Expense:
EMBASSY® digital security products and services	130,815			182,579			257,063			363,303
Wavexpress broadband media distribution	44,520			23,473			66,440			50,333
Total Depreciation and Amortization Expense	175,335			206,052			323,503			413,636
Capital Expenditures:
EMBASSY® digital security products and services	94,762			36,762			143,066			48,173
Wavexpress broadband media distribution	31,945			—			35,362			2,638
Total Capital Expenditures	$	126,707		$	36,762		$	178,428		$	50,811

	June 30,		December 31,
	2006		2005
Assets:
EMBASSY^® Trusted Client Platform and services	$	3,620,571	$	3,235,946
Wavexpress Data Broadcasting	94,763		193,819
Total Assets	$	3,715,334	$	3,429,765

8. Issuance of Common Stock

On May 8, 2006, Wave received gross proceeds of $625,000 less placement agent fees of $25,000 for net proceeds of $600,000, in connection with the issuance of 276,620 shares of Class A Common Stock upon the exercise of two warrants that were granted to an investor as part of Wave’s December 5, 2005 financing and February 15, 2006 financing. The warrant issued to this investor in connection with the December 5, 2005 financing was exercised in full for 114,583 shares of Class A Common Stock at an exercise price of $2.40 per share. The warrant issued to the investor in connection with the February 15, 2006 financing was exercised in full for 162,037 shares of Class A Common Stock at an exercise price of $2.16 per share.

On May 3, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 2,012,500 shares of Class A Common Stock to certain purchasers for an aggregate purchase price of $4,830,000. The shares were priced at $2.40 per share. Securities Research Associates, Inc. (“SRA”) entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering. Wave also agreed to issue a warrant to SRA to purchase up to 100,625 shares of Class A common stock at an exercise price of $2.40. The Warrant will be exercisable for a period of thirteen months following the date of the transaction. Wave realized net proceeds of approximately $4,548,400 after deducting the placement agent fees of $241,500 and additional legal and other fees associated with the issuance of these securities, which Wave estimates will be approximately $40,000. The shares were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and declared effective by the Securities and Exchange Commission (the “SEC”) on January 13, 2006.

On February 15, 2006, Wave entered into a securities purchase agreement, pursuant to which Wave agreed to sell and issue 2,782,866 shares of Class A Common Stock for $1.605 per share, to certain purchasers for an aggregate purchase price of $4,466,500. The purchasers were also granted warrants (the “Warrants”) to purchase up to 516,956 shares of Class A common stock at an exercise price of $2.16. The Warrants are exercisable for a period of six months following the date of issuance. Each Warrant is subject to cancellation if the closing bid price of Wave’s common stock exceeds $2.58 for 10 out of 20 consecutive trading days and the Warrant has not been exercised by the close of business on the trading day after the 10th trading day on which the closing bid price exceeds $2.58. The placement agent, JPC Capital Partners, Inc. (formerly Corpfin, Inc.) (the “Placement Agent”) had entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay the Placement Agent a fee equal to 4.0% of the gross proceeds of this offering. Wave realized net proceeds of $4,250,211 after deducting the placement agent fees of $216,289 and additional legal and other fees associated with the issuance of these securities. The shares were issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and declared effective by the Securities and Exchange Commission (the “SEC”) on January 13, 2006.

9. Subsequent Events

On August 4, 2006, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 2,336,752 shares of Class A Common Stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $4,790,342. These shares were priced at $2.05 per share. SRA entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering. Wave agreed to pay SRA a fee equal to 5.0% of the gross proceeds of this offering. Wave also agreed to issue a warrant to SRA to purchase up to 116,837 shares of Class A common stock at an exercise price of $2.05. The Warrant expires on September 3, 2007. Wave expects to realized net proceeds of approximately $4,520,800 after deducting the placement agent fees of $239,500 and additional legal and other fees associated with the issuance of these securities, which Wave estimates will be approximately $30,000. The shares sold on August 4, 2006 were offered and issued pursuant to a shelf registration statement which was filed by Wave on December 16, 2005 and declared effective by the Securities and Exchange Commission (the “SEC”) on January 13, 2006.

CERTAIN FORWARD-LOOKING INFORMATION:

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

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

On July 24, 2006, our Board of Directors approved a reverse stock split of our common stock at a ratio of one-for-three, causing each three outstanding shares of Class A common stock and Class B common stock to convert automatically into one share of Class A common stock or Class B common stock, respectively. The par value of Class A common stock and Class B common stock remains $0.01 per share. The reverse split became effective at the close of business on July 25, 2006. In lieu of fractional shares, stockholders will receive a cash payment based on an average trading price of the Class A common stock prior to the effectiveness of the reverse split. Except as otherwise noted, all references to common share and per common share amounts (including warrant shares, option shares, shares reserved for issuance and applicable exercise prices) for all periods presented herein have been retroactively restated to reflect this reverse split.

Overview

Our Business

Wave Systems Corp. develops, produces and markets products for hardware-based digital security, including security applications and services that are complementary to and work with the specifications of the Trusted Computing Group, www.trustedcomputinggroup.org (“TCG”). Specifications developed by the TCG are designed to address a broad range of current and evolving digital security issues. These issues include: identity protection, data security, digital signatures, electronic transaction integrity, platform trustworthiness, network security, and regulatory compliance.

The TCG is an industry standards body, comprised of computer and device manufacturers, software vendors and others, whose purpose is to develop, define and promote open industry standard specifications for embedded hardware-enabled computing products, including security technologies across multiple platforms, peripherals and devices. The current TCG specification recommends a hardware-based trusted computing platform, which is a platform that uses an implementation of the TPM specification in a semiconductor device, known as a Trusted Platform Module (“TPM”) that performs protected activities, including protected storage, platform authentication, protected cryptographic processes and attestable state capabilities to provide the first level of trust for the computing platform (a “Trusted Platform”). The TPM is a hardware chip that is separate from the platform’s main CPU(s) that enables secure protection of files and other digital secrets, and performs critical security functions such as generating, storing and protecting “cryptographic keys,” which are secret codes used to decipher encrypted or coded data. While TPMs provide the anchor for hardware security, known as the “root of trust”, trust is achieved by integrating the TPM within a carefully architected trust infrastructure and supporting the TPM with essential operational and lifecycle services, such as key management and credential authentication.

In 2003, Wave began the market introduction of its first commercial products designed to support the first emerging products that include TPMs in this marketplace. Through 2005, Wave continued to develop enhancements to its existing products and has developed additional products in support of the emerging TCG-specifications. Wave continued to develop these products during the first six months of 2006.

As the market for TPM-enabled products developed, with computing devices being shipped in volume by leaders in the PC industry, Wave has developed its products to support security hardware, based on the TCG specifications. Wave’s products are unique because they support cross platform interoperability for the currently available TPM chips from Winbond Electronics Corp. (“WEC”), Broadcom, Atmel, Infineon and ST Microsystems, and have been certified and/or approved for usage on TPM-based platforms shipped by Dell, Intel, Gateway, IBM and HP.

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

The market trends and opportunities on which management focused its activities on during the quarter ended June 30, 2006 included the following:

• A new study by Infonetics forecasts sharp rises in end-point security. The study predicts that in the coming years, endpoint security will require a range of new types of software and hardware to be effective, including endpoint-security appliances and improved network-infrastructure equipment. Accordingly, the study forecasts the overall network access control (NAC) enforcement market will grow to $3.9 billion by 2008, up from just $323 million last year, a 1101 percent increase. More information is available from the IT Compliance Institute.

• Adoption of TPMs and Trusted Computing technology is also growing – according to industry analyst, IDC, shipments of TPMs are expected to grow from under 25 million units in 2005 to over 250 million units in 2010.

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

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

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

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

• In its Windows Vista Logo Program for Systems, Version 3.0, Draft Revision 0.7, Microsoft has required TPM version 1.2 in its draft operating system hardware requirements specification for logo compliance for “Gold” level business PCs. Wave believes that a significant percentage of the approximately 150 million unit PC market will include TPMs by December 2006, which is Microsoft’s stated launch date for Vista for business PCs.

• The emergence of additional trusted PC components, such as Seagate’s Momentus 5400 Full Disc Encryption drive which was announced in Q3 of 2005, represent additional opportunities for Wave’s products to support and integrate these devices with the TPM elements in the PC.

• On February 3, 2006, the U.S. Army, in the new Consolidated Buy-2 (CB2) Desktop and Notebook minimum specifications for Army customers as published by the Army Small Computer Program, specifies the requirement for desktop and laptop personal computers to be equipped with new open security chip hardware called the Trusted Platform Module (TPM).

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

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

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

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

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

As more PC and chip original equipment manufacturers (“OEMs”) have begun introducing their Trusted Platform offerings, Wave’s management has focused on entering into licensing contracts in which the OEM licenses our applications and bundles them with their offering, paying Wave a royalty for each unit shipped. Wave currently has signed such bundling agreements with seven separate OEM partners. In addition, we have sought to develop our products so that they operate on all of the Trusted Platforms of the major chip OEMs currently shipping product in the marketplace. Our applications have been approved to work with the Trusted Platforms of Dell, Intel, Gateway, IBM, HP, WEC, Atmel, Broadcom, Infineon, ST Microsystems and others.

Management is also focused on developing the client and server-side applications and tools that will enable enterprises to manage an IT infrastructure that relies on TCG hardware-enabled security. Wave is

devoting a significant portion of its research and development budget to address this opportunity, as this will be a key ingredient for enterprises to successfully implement a Trusted Platform solution. Wave released these tools and applications in 2004, and has signed license agreements in 2005 and 2006 for Wave’s TCG-Enabled Toolkit, EMBASSY Key Management Server and EMBASSY Authentication Server.

With respect to sales and marketing, management is focused on broadening our distribution strategies to include the direct engagement of our channel partners using their resellers and systems integrators and has hired regional representation in Japan. We have also expanded our targeted presence selling directly to OEMs. We have specifically focused many of our resources towards solution selling in these channels. As an example of our channel partner relationship strategy, in July 2006 Wave signed a reseller agreement with NTT Data Corporation (“NTT”), a Japanese information technology systems integrator, pursuant to which NTT is authorized to resell Wave’s products and solutions and to provide support services to NTTs customers in an effort to introduce those products and solutions to the Japanese enterprise market.

Management is also focused on opportunities for its eTMS product suite to provide digital signing and document management solutions to the financial services and other vertical markets in which there is a clear and identifiable value proposition in implementing these solutions. Although we have met significant implementation challenges and long sales cycles with this effort, we have also entered into contracts with a la mode, inc. in the real estate industry in 2004 and with Efficient Forms, LLC in the financial services sector in 2005 and 2006. We continue to pursue additional opportunities for the eTMS product line.

Wavexpress is focused on building a sustainable revenue stream by establishing partnerships with branded content providers to provide paid and advertising supported video entertainment services. Wavexpress’ TVTonic service has recently added new content partners and has been designed to support any video channel distributed via RSS. RSS is the standard format for blogs and podcasts and is being increasingly used for open video distribution on the Internet. It is intended that TVTonic will be an advertising supported service. TVTonic is currently being promoted with all Microsoft Media Center Edition PCs through their Online Spotlight partner program. In addition, Wavexpress is extending its technology so that its subscriber management system can leverage the added security of a TPM and is preparing back-office systems for standalone deployment into enterprise installations.

Wavexpress currently has one contract that is generating revenue in 2006. Management plans to devote on-going development resources toward enhancing the TVTonic client software and services.

Our Products

Client-side Applications

The EMBASSY Trust Suite

The current version of the EMBASSY Trust Suite is a set of applications and services that are designed to bring functionality and user value to TPM-equipped products. Designed to make the TPM easy for users to set up and use, the EMBASSY Trust Suite includes the EMBASSY Security Center (the “ESC”), Document Manager Vault (“Vault”), Private Information Manager (“PIM”), SmartSignature and Key Transfer Manager (“KTM”).

The ESC enables the user to set up and configure the TPM platform. In addition to the basic function of making the TPM operational, ESC is designed to enable the user to manage extended TPM-based security settings and policies, including strong authentication, Windows logon preferences to add biometrics and streamlined password policy management. Wave also announced that it would develop the Trusted Drive Manager functions for ESC to support the newly announced Seagate Full Disc Encryption drives.

Data Protection is addressed by the Vault, which provides document encryption, decryption and client side storage of documents. The Vault, which works with Microsoft Windows, and Microsoft Office, secures documents against unauthorized users and hackers.

Password management is a security challenge due to the increasing number of passwords required and the tendency of users to select easily guessed passwords. To help improve these password issues, PIM uses the TPM to securely store and manage user information such as user names, passwords, credit card numbers and other personal information. It retrieves login information to efficiently fill in applications, web forms and web login information.

Backup and recovery of keys used for logon, signing, and protection of data is an essential requirement for deployment of TPM based systems. KTM is an archive application for the cryptographic keys that is designed to provide a simple, yet fully featured method to securely archive, restore and transfer keys having migratable properties that are secured by the TPM.

SmartSignature is a digital signing application that utilizes the signing keys generated by the TPM.

Additionally, Wave has developed TPM Wizards as part of the EMBASSY Trust Suite which allow users to setup and use the TPM for securing 802.11x wireless networks, the Windows Encrypting File System and encrypting email. The TPM Wizard enhancement was released during the 1st quarter of 2005.

In August 2005, Wave signed an agreement with Seagate Technology LLC (“Seagate”) to develop a trusted drive manager software module for the EMBASSY Trust Suite, which will support the Seagate Momentus 5400 Full Disc Encryption products announced by Seagate (the “Seagate Trusted Drives”). Wave’s support for the Seagate Trusted Drives will also utilize its EMBASSY Trust Suite software for TPM and key management.

Wave plans to continue to develop and enhance the current products being developed within this product group and will develop new applications and services as the trusted computing market continues to evolve. Current planned development costs for this product group are expected to be approximately $2.5 million for the twelve-month period ending June 30, 2007.

Middleware and Tools

TCG-Enabled Toolkit

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

Wave TCG-Enabled Cryptographic Service Provider (“CSP”)

Wave offers a TCG-enabled CSP, which allows software developers to utilize the enhanced security of a TCG standards-based platform, facilitating a common user experience independent of the platform. It also enables applications to utilize functionality available on TCG-compliant platforms directly through the Microsoft cryptographic application programming interface, without requiring user knowledge of any specific TCG software stack layer.

Current planned development costs for this product group are expected to be approximately $3.4 million for the twelve-month period ending June 30, 2007.

EMBASSY Trust Server Applications

EMBASSY Key Management Server (EKMS)

EKMS is a server application that is designed to provide corporate-level backup and transition of the TPM keys, a process known as key migration. Key migration using EKMS is designed to help prevent the risk of serious data loss in the event that a TPM, hard drive or motherboard becomes corrupted, or a user leaves the organization. For instance, an organization may require access to a former employee’s encrypted data or TPM-secured keys for business continuity or disaster recovery purposes. EKMS enables enterprise level key protection services while ensuring proper archive procedures and recovery capabilities.

EMBASSY Authentication Server (EAS)

EAS provides centralized management, provisioning and enforcement of multifactor domain access policies. With EAS, authentication policies can be based on TPM credentials, Smart Card credentials, user passwords and fingerprint templates. With EAS, authentication policies can be provisioned and managed from the domain controller. EAS has an integrated biometric template capability with support for a variety of 3^rd-party vendors.

Current planned development costs for this product are expected to be approximately $1.3 million for the twelve-month period ending June 30, 2007.

Digital Signature and Electronic Document Management

On October 4, 2001, Wave acquired the digital signature and electronic document management technology, SmartSignature and SmartSAFE, from SignOnLine, Inc. (“SignOnLine”), a California-based company. This group of products initially made up our eSign Transaction Management Suite, also known as eTMS (“eTMS”), which consisted of four core products: SmartIdentity, SmartSignature, SmartSAFE and SmartConnect. SmartSignature Version 3.0 is a digital signature application that connects signers and institutions – banks, insurance companies, enterprises, etc. – through a legally binding digital signature. In Q4 of 2005, Wave launched SmartSignature Server, a server-side electronic signature application, which enables individuals to electronically sign and store virtually any format of document, while connected to a server, as opposed to the signing taking place on the client PC.

To increase the security associated with identity protection and digital signing credentials, Wave’s SmartSignature is currently enabled for the support of TPMs. SmartSAFE Version 3.0 is a web-based document management application where signed documents are archived and tracked. SmartSAFE provides an easy to use environment where a client institution can view, manage, store and transfer sensitive signed and unsigned documents. SmartSAFE also supports archival and management of unsigned documents in virtually any format. These products allow a document to be executed, verified, accepted and filed in minutes at a lower cost compared to traditional paper-based documentation methods. SmartSignature Version 3.0 and SmartSAFE Version 3.0 have been completed and Wave commercially released these products in the first quarter of 2003. SmartIdentity, an optional service to verify a signer’s identity through strong authentication methods, including issuing encrypted digital certificates based on public key infrastructure technology, was completed and released in January of 2003. Wave will continue to allocate resources toward marketing and sales to promote these products.

Wave’s eTMS, in addition to being part of the EMBASSY Trust Suite applications and supporting TPMs, is also being independently marketed in the insurance, mortgage, finance, government and other markets which are seeking digital and electronic signature solutions that are compliant with the Electronic Signatures in Global and National Commerce Act (“ESIGN”). In 2005, eTMS’ SmartSignature Server product was licensed to a la mode, Inc., a leading provider of desktop, mobile, and Web tools for the real estate and mortgage industries, to provide digital signature solutions for their XSites product line. Wave also signed licensing agreements in 2005 and in the 2^nd quarter of 2006 with Efficient Forms, LLC, a leading provider of interview-based electronic forms creation, to offer a comprehensive managed-service solution for electronic forms and electronic signatures. In Q4 of 2005, the Wave/Efficient Forms managed service was launched, and deployed at FISERV ISS to automate internal and consumer business processes. Wave has focused on digital signature applications that can make effective use of the stronger security features provided by trusted computing platforms.

Current planned development costs for this product are expected to be approximately $451,000 for the year ending June 30, 2007.

Broadband Media Distribution Services

Wave offers broadband content distribution products and services through Wavexpress, a joint venture between Wave and Sarnoff Corporation. The joint venture was established on October 15, 1999. Under the joint venture agreement, Sarnoff and its affiliates received a 40% equity stake in Wavexpress. Wave received a 53% equity interest and its affiliates, who purchased founders stock in April 1999 for a nominal

amount, owned the remaining 7% of the outstanding capital stock. The affiliates of Wave include Peter Sprague, former Chairman of Wave, Steven Sprague, Chief Executive Officer of Wave, certain members of the Board of Directors of Wave and certain Wave employees.

Wavexpress has developed a vertically integrated suite of products designed to enable the optimum broadband distribution of digital programming. The current product offering combines industry standard syndication protocols with proprietary back-end software to create an end-to-end content syndication and monetization platform. This system is offered to content providers looking to deliver high-quality broadband media services using either Wavexpress’ distribution facility or on their own, through Really Simple Syndication (“RSS”). RSS is the standard format for blogs and podcasts and is being increasingly used for open video distribution on the Internet. Content providers connect through the Wavexpress client and backend software to generate advertising revenue or subscription fees for premium services. Wavexpress’ business model intends to derive revenue either from direct fees charged to content providers for the use of Wavexpress software and facilities, or from a share of advertising proceeds collected. Wavexpress proprietary client software is integrated and promoted through Microsoft’s Media Center Edition operating system, as well as with Microsoft’s Internet Explorer web browser.

We believe Wavexpress’ products deliver value to content providers by bringing a traditional advertising sales model to the emerging market for cached, syndicated, high-quality video content. By leveraging an open standard, RSS, Wavexpress believes it is in a position to work with any content provider – large or small. Wavexpress’ investment in proprietary backend and distribution technology creates opportunities to differentiate and capitalize on this rapidly growing segment of the content industry.

Planned future development expenditures are expected to approximate $1.3 million for the year ending June 30, 2007. As of June 30, 2006, Wave owned 69% of Wavexpress and Sarnoff owned 25.6%.

Our Market

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

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

R&D

Wave has realized minimal operating revenues since its inception. At June 30, 2006, Wave had an accumulated deficit of approximately $294.3 million. Wave has made a substantial investment in research

and development including approximately $4 million for the six-month period ended June 30, 2006, and expects to continue to make substantial investments in its products and technology. For the years ended December 31, 2005, 2004 and 2003, Wave spent approximately $6.9 million, $6.9 million and $7.4 million, respectively, on research and development activities.

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

Critical Accounting Policies

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

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

Method of Accounting for Joint Ventures - Wave accounts for its investments in joint ventures using the equity method of accounting when its ownership interest in the joint venture is less than fifty percent and it is determined that Wave has the ability to exercise significant influence over the joint venture’s operating and financial policies. The financial statements of joint ventures in which Wave owns greater than a fifty percent interest are consolidated with Wave’s financial statements pursuant to APB Opinion No. 18.

Research and Development and Software Development Costs - Research and development costs are expensed as incurred. Software development costs are accounted for pursuant to SFAS No. 86 “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed” (“SFAS No. 86”). SFAS No. 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development costs until technological feasibility is established for the product. Once technological feasibility is established and the product has achieved commercial marketability, all development costs should be capitalized until the product is available for general release to customers. We consider technological feasibility to be established upon completion of a detail program design or in the absence of a detail program design, upon completion of a working model of the software, as defined in SFAS No. 86. Judgment is required in determining when the technological feasibility of a product is established, if the product has achieved commercial marketability and in estimating the life of the product for which the capitalized costs will be amortized.

Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed - Wave reviews the valuation of long-lived assets, including property and equipment and capitalized software, under the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”) and SFAS No. 86. Wave is required to assess the recoverability of long-lived assets and

capitalized software costs whenever events and circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could trigger an impairment review include the following:

• significant underperformance relative to expected historical or projected future operating results;

• significant changes in the manner of our use of the acquired as sets or the strategy of our overall business;

• significant negative industry or economic trends; and

• 0; significant decline in our stock price for a sustained period.

In accordance with SFAS No. 144, when we determine that the carrying value of applicable long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we evaluate whether the carrying amount of the asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of that asset. If such a circumstance exists, we would measure an impairment loss to the extent the carrying amount of the particular long-lived asset or group exceeds its fair value. We would determine the fair value based on a projected d iscounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. In accordance with SFAS No. 86, when we determine that the carrying value of certain other types of long-lived assets may not be recoverable, we evaluate whether the unamortized cost exceeds the expected future net realizable value of the products. If the unamortized costs exceed the expected future net realizable value of the products, the excess amount is written off. Changes in judgments on any of these factors could impact the value of the asset being evaluated.

Revenue Recognition – Wave’s business model targets revenues from various sources including: licensing of EMBASSY Trust Suite, EMBASSY Trust Server, Wavexpress’ broadband media distribution and eTMS software products and professional service contracts. Many of our sales arrangements include multiple elements, and in some cases require significant modification or customization of our software.

Wave follows the provisions of statement of position “SOP” 97-2, Software Revenue Recognition as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Generally, Wave recognizes revenue when it is realized or realizable and earned. Wave considers revenue realized or realizable and earned when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Wave reduces revenue for estimated customer returns, rotations and sales rebates when such amounts can be estimated. When these amounts cannot be estimated Wave defers revenue until the product is sold to the end-user. Revenue from software license agreements that have significant customizations and modification of the software product is deferred and recognized in a manner that approximates the percentage of completion method. In addition to the aforementioned general policy, the following are the specific revenue recognition policies for each major category of revenue.

SOFTWARE

Revenue from delivered elements of one-time charge licensed software is recognized at the inception of the license term, provided Wave has vendor-specific objective evidence of the fair value of each undelivered element for arrangements that contain multiple elements. Revenue is deferred for undelivered elements for these arrangements. Revenue is also deferred for the entire arrangement, if vendor-specific objective evidence does not exist for each undelivered contract element. Examples of undelivered elements in which the timing of delivery is uncertain include contractual elements that give customers rights to any future upgrades at no additional charge or future maintenance that is provided within the overall price. The revenue that is deferred for any contract element is recognized when all of the revenue recognition criteria have been met for that element.

Prepaid royalty fees received pursuant to distribution software licenses with OEMs in which Wave earns a royalty, based upon units shipped by the OEM to end customers, are deferred when received, and recognized as revenue as units are shipped by the OEM.

SERVICES

Revenue from time and material service contracts is recognized as the services are provided. Revenue from fixed price, long-term service or development contracts is recognized over the contract term based on the percentage of services that are provided during the period compared with the total estimated services to be provided over the entire contract. Losses on fixed price contracts are recognized during the period in which the loss first becomes apparent. Payment terms vary by contract.

Share-based Payment - - On January 1, 2006, Wave adopted Statement of Financial Accounting Standards No. 123 (R), “Share-Based Payment,” (“SFAS No. 123(R)”) which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options and employee stock purchases based on estimated fair values. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS No. 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

Wave adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006. In accordance with the modified prospective transition method, Wave’s consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). Stock-based compensation expense recognized under SFAS No. 123(R) for the quarter and six-month period ended June 30, 2006 was $407,838 and $760,575, respectively. There was no stock-based compensation expense recognized during the quarter and six month period ended June 30, 2006.

Wave uses the Black-Scholes-Merton option pricing model to value stock options. The Black-Scholes-Merton model requires the use of employee exercise behavior data and the use of a number of assumptions including volatility of the company’s stock price, the weighted average risk-free interest rate, and the weighted average expected term of the options. As Wave does not pay dividends, the dividend rate variable in the Black-Scholes-Merton model is zero. The following values for the indicated variables were used to value options granted during the quarter ended June 30, 2006; and we expect the assumptions used for grants in future quarters of fiscal 2006 to approximate these values.

	Quarter ended June 30, 2006
Expected Term (in years)	5 Years
Risk-free Rate	4.765% - 5.105	%
Expected Volatility	99.3	%
Dividend Yield	0.0	%

The risk-free interest rate assumption is based upon the implied yield available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term of the option granted.

As stock-based compensation expense recognized in the consolidated statement of operations pursuant to SFAS No. 123(R) is based on awards ultimately expected to vest, expense for grants beginning upon adoption of SFAS No. 123(R) on January 1, 2006 is reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based primarily on historical experience.

Results of Operations

Three Months Ended June 30, 2006 and 2005

Wave had revenues of $910,445 and $257,655 for the three months ended June 30, 2006 and 2005, respectively. Licensing revenues increased by $438,515, primarily due to higher volume of shipments of Wave’s OEM customer products for which Wave receives royalty income. Services revenue increased by $214,275 due to revenue from government time-and-materials contracts that were entered into during the first quarter of 2006.

The table below sets forth the components that make up the revenue for the quarters ended June 30:

	2006		2005		Increase/ (Decrease)		% Change
Licensing	$	682,645	$	244,130	$	438,515	180	%
Services	227,800		13,525		214,275		1584	%
Total Net Revenues	$	910,445	$	257,655	$	652,790	253	%

Cost of sales for the three months ended June 30, 2006, was $355,842 compared with $176,884 for the same period in 2005. The increase in costs of sales was due to costs associated with time-and-materials contract revenue during the June 30, 2006 quarter versus the prior year quarter and higher support costs in connection with the increased license revenue in the quarter ended June 30, 2006 versus 2005.

Selling, general and administrative (“SG&A) expenses for the three months ended June 30, 2006 were $3,211,845 as compared to $2,937,271 for the comparable period of 2005, an increase of approximately 9%. The increase was due mainly to non-cash, share-based compensation expense totaling approximately $248,000 for Wave and approximately $28,000 for Wavexpress that was incurred in the quarter ended June 30, 2006, in accordance with SFAS 123(R). This expense was not incurred in the quarter ended June 30, 2005 because Wave did not adopt SFAS 123(R) until its effective date of January 1, 2006. Included in the SG&A expenses listed above are Wavexpress’ selling, general and administrative expenses, which were $278,175 and $258,151 for the quarters ended June 30, 2006 and 2005, respectively. This 8% increase was due primarily to share-based non-cash compensation referred to above.

Selling, general and administrative expenses are expected to remain relatively flat over the foreseeable future depending upon the business needs of Wave. The activities supported by these expenditures include business development, sales, marketing (including product development and product management), corporate communications and public relations, information technology and management information systems, human resources, accounting, executive management, corporate governance and general administrative functions. Given the early stage nature of the markets for products that use our technology, we have expended and will continue to expend considerable resources in the sales, marketing, business development and support activities referred to above that will be necessary for us to be successful in developing salable products and markets for our technology.

Research and development expenses for the three months ended June 30, 2006 were $1,912,122 as compared to $1,669,644 for the comparable period of 2005, an increase of 15%. This increase was primarily attributable to increased salaries, fringe and benefit expenditures of approximately $164,000 at Wave associated with salary increases and headcount additions to accommodate additional research and development efforts which exceed those in the three months ended June 30, 2005. The increase was due also to non-cash, share-based compensation expense totaling approximately $102,000 for Wave and approximately $16,000 for Wavexpress that was incurred in the quarter ended June 30, 2006, in accordance with SFAS 123(R). Wavexpress’ research and development expenditures included in the above were approximately $313,211 and $286,691 for the quarters ended June 30, 2006 and 2005, respectively, for an increase of approximately 9%, due primarily to the reasons set forth above.

Interest income for the three months ended June 30, 2006 was $30,255 as compared to $18,934 for the comparable period of 2005. The increase in interest income is primarily attributable to a higher rate of interest earned on Wave’s money market accounts for the quarter ended June 30, 2006 compared with the same period in 2005.

For the quarter ended June 30, 2006, Wave recorded no gain or loss, in connection with the value of the outstanding warrants containing net cash settlement features, versus a gain of $347,285 for the quarter ended June 30, 2005. These warrants were granted in connection with a private placement of Class A Common Stock completed on November 18, 2003. The liability, calculated using the Black-Scholes option pricing model, was valued at $0 as of June 30, 2006. The gain for the quarter ended June 30, 2005 was primarily the result of the decrease in the quoted closing price on the Nasdaq National Exchange of Wave’s Class A Common Stock from March 31, 2005 to June 30, 2005. Because the price of Wave’s Class A Common Stock decreased, the fair value of the warrants decreased as well, resulting in the gain.

Due to the reasons set forth above, our net loss to common stockholders for the three months ended June 30, 2006 was $4,539,108 as compared to $4,159,925 for the comparable period of 2005.

Six Months Ended June 30, 2006 and 2005

Wave had revenues of $1,403,559 and $335,531 for the six-month period ended June 30, 2006 and 2005, respectively. Licensing revenues increased by $675,898, primarily due to higher volume of shipments of Wave’s OEM customer products for which Wave receives royalty income. Services revenue increased by $392,130 due to revenue from government time-and-materials contracts that were signed subsequent to the end of the prior year during the first quarter of 2006.

The table below sets forth the components that make up the revenue for the six-month period ended June 30, 2006 and 2005:

	2006		2005		Increase/ (Decrease)		% Change
Licensing	$	991,047	$	315,149	$	675,898	214	%
Services	412,512		20,382		392,130		1924	%
Total Net Revenues	$	1,403,559	$	335,531	$	1,068,028	318	%

Cost of sales for the six-month period ended June 30, 2006, was $570,919 compared with $346,002 for the same period in 2005. The increase in costs of sales was due to costs associated with time-and-materials contract revenue during the June 30, 2006 quarter versus the prior year quarter.

SG&A expenses for the six months ended June 30, 2006 were $6,402,259, as compared to $5,933,862 for the comparable period of 2005, an increase of approximately 8%. The increase was due mainly to non-cash, share-based compensation expense totaling approximately $487,000 for Wave and $46,000 for Wavexpress that was incurred in the six-month period ended June 30, 2006, in accordance with SFAS 123(R). This expense was not incurred in the six-month period ended June 30, 2005 because Wave did not

adopt SFAS 123(R) until its effective date of January 1, 2006. This increase was offset by a decrease in salary and fringe expense of approximately $51,000 resulting from a headcount reduction in SG&A, and reduction in travel and entertainment expenses of approximately $32,000. Included in the SG&A expenses listed above are Wavexpress’ selling, general and administrative expenses, which were $601,865 and $550,539 for the six-month periods ended June 30, 2006 and 2005, respectively. This 9% increase was due primarily to the share-based non-cash compensation expense referred to above.

SG&A expenses are expected to remain relatively flat over the foreseeable future depending upon the business needs of Wave. The activities supported by these expenditures include business development, sales, marketing (including product development and product management), corporate communications and public relations, information technology and management information systems, human resources, accounting, executive management, corporate governance and general administrative functions. Given the early stage nature of the markets for products that use our technology, we have expended and will continue to expend considerable resources, in the sales, marketing, business development and support activities referred to above that will be necessary for us to be successful in developing products and markets for our technology.

Research and development expenses for the six months ended June 30, 2006 were $4,012,500, as compared to $3,264,102 for the comparable period of 2005, an increase of 23%. This increase was primarily attributable to increased salaries, fringe and benefit expenditures of approximately $508,000 at Wave associated with salary increases and headcount additions to accommodate additional research and development efforts that were undertaken since June 30, 2005. Wave also increased temporary consulting expenses by approximately $117,000 to support these efforts. In addition, non-cash, share-based compensation expense was approximately $184,000 at Wave and $26,000 at Wavexpress in connection with the adoption of SFAS 123(R) on January 1, 2006. Wavexpress’ research and development expenditures included in the above were approximately $595,949 and $594,129 for the six-month periods ended June 30, 2006 and 2005, respectively, for an increase of less than 1%. The increase in Wavexpress R&D expense due to the share-based compensation above was offset by an net decrease in personnel expenses of approximately $25,000 associated with lower headcount and lower average salaries versus the prior year quarter.

Interest income for the six months ended June 30, 2006 was $48,310 as compared to $40,070 for the comparable period of 2005. The increase in interest income is primarily attributable to an increase in interest rates earned on Wave’s money market accounts for the six-month period ended June 30, 2006 compared with the same period in 2005.

For the six months ended June 30, 2006, Wave recorded a gain, in connection with the value of the outstanding warrants containing net cash settlement features of $2,794, versus a gain of $462,860 for the six-month period ended June 30, 2005. These warrants were granted in connection with a private placement of Class A Common Stock completed on November 18, 2003. The liability, calculated using the Black-Scholes option pricing model, was valued at $2,794 as of December 31, 2005, and $0 as of June 30, 2006. The gain was primarily the result of the decrease in the quoted closing price on the Nasdaq National Exchange of Wave’s Class A Common Stock from December 31, 2005 to June 30, 2006. Because the price of Wave’s Class A Common Stock declined, the fair value of the warrant liability decreased, as well resulting in the gain.

Due to the reasons set forth above, our net loss to common stockholders for the six months ended June 30, 2006 was $9,531,014 as compared to $8,705,505 for the comparable period of 2005.

Liquidity and Capital Resources

Wave has experienced net losses and negative cash flow from its operations since its inception, and, as of June 30, 2006, had an accumulated deficit of $294,277,840. Total stockholders’ equity as of June 30, 2006

was $624,794. Wave has financed its operations through June 30, 2006 principally through the issuance of Class A and B Common Stock and various series’ of preferred stock.

Sources and uses of cash

As of June 30, 2006, Wave had $1,891,166 in cash and cash equivalents. As of December 31, 2005, Wave had $2,006,022 in cash and cash equivalents. The decrease in cash and cash equivalents of $114,856, resulted from $9,497,470 used in operating activities, $178,428 used in investing activities for the acquisition of capital assets; offset by $9,561,042 generated through financing activities, from the sale of 5,154,692 shares of Class A Common Stock, including 82,706 shares sold pursuant to Wave’s Employee Stock Purchase Plan. At June 30, 2006, Wave had negative working capital of $118,551.

Liquidity requirements and future sources of capital

Wave estimates that its total expenditures to fund operations for the twelve months ending June 30, 2007 will be approximately $20,700,000, including research and development, acquisition of capital assets, sales and marketing, general corporate expenses and overhead.

Expected sources of capital include the following:

• cash on hand of $1,891,166 as of June 30, 2006

• cash from sales and licensing of products

• additional financings including the sale on August 4, 2006 of 2,336,752 shares of common stock for gross proceeds of $4,790,342 for which we expect to receive $4,520,800 after subtracting placement agent and other fees

Given Wave’s capital requirements for the twelve-month period ending June 30, 2007 as indicated above, and Wave’s cash on hand as of June 30, 2006, Wave will be required to raise additional capital to fund its operations.

We plan to obtain additional funding from further sales of newly issued shares of Class A Common Stock including the sale of Class A Common Stock under the remaining availability of two $25,000,000 shelf registration statements; one that we filed on April 15, 2004 that the SEC declared effective on May 10, 2004 and one that we filed on December 16, 2005 that the SEC declared effective on January 13, 2006. Since their effective dates, we have completed several sales of Class A Common Stock under these registration statements.

The remaining availability under the two shelf registrations is approximately $13,069,000, of which $1,248,000 is reserved for the unexercised warrants which expire during the period between August 15, 2006 through September 4, 2007. We can provide no assurances as to whether we will be successful in raising the needed capital to continue as a going concern.

Revenue outlook

During 2003, Wave began licensing its EMBASSY Trust Suite software through bundling arrangements with OEMs with whom it signed contracts during the year. In addition, Wave received revenues from software development and other services. Total cash received from all revenue sources in 2005 was approximately $961,000. As of June 30, 2006, we have received approximately $787,000.

In November of 2005, Wave signed a new OEM distribution agreement with Dell that permits Dell to distribute Wave software on certain Dell TPM-equipped business PCs. Wave is being paid a per unit royalty fee for each Dell product shipment which includes Wave’s software. In addition, pursuant to this same agreement, Dell is offering an upgrade package of Wave’s software that purchasers of certain models of TPM-equipped computers may buy. Wave will be paid a license fee, for each copy of the upgrade package that is purchased. We are working with Dell to market our products in an effort to drive volume of purchases of the upgrade package. However, we have no reliable basis to predict how many upgrade

packages will be purchased, and what the resultant revenue to Wave might be from this program. There are no minimum royalty or shipped quantity requirements.

In January of 2006, Wave signed a distribution agreement with Gateway that permits Gateway to distribute Wave software on Gateway TPM-equipped models. Wave is being paid a per unit royalty fee for each Gateway shipment which includes Wave’s software. In addition, pursuant to this same agreement, it Gateway is offering an upgrade package of Wave’s software that purchasers of certain models of TPM-equipped computers may buy. Wave will be paid a license fee, for each copy of the upgrade package that is purchased. We are working with Gateway to market our products in an effort to drive volume of purchases of the upgrade package. However, we have no reliable basis to predict how many upgrade packages will be purchased, and what the resultant revenue to Wave might be from this program. There are no minimum royalty or shipped quantity requirements.

In March of 2006, Wave signed a distribution agreement with Broadcom Corporation (“Broadcom”) that permits Broadcom to distribute Wave software on Broadcom TPM-equipped hardware devices. Wave is being paid a per unit royalty fee for each Broadcom shipment which includes Wave’s software. We are working with Broadcom to market our products in an effort to drive volume of shipments of their TPM-equipped products. However, we have no reliable basis to predict how many of Broadcom’s TPM-equipped products will be purchased, and what the resultant revenue to Wave might be from this program. Although we have received a prepaid royalty, there are no minimum royalty or shipped quantity requirements.

In April of 2006, Wave signed a software license agreement with Winbond Electronics Corporation (“WEC”) that permits WEC to distribute Wave software on WEC TPM-equipped hardware devices. Wave will be paid a per unit royalty fee for each WEC shipment which includes Wave’s software. We are working with WEC to market our products in an effort to drive volume of shipments of their TPM-equipped products. However, we have no reliable basis to predict how many of WEC’s TPM-equipped products will be purchased, and what the resultant revenue to Wave might be from this program. Although we are to receive a prepaid royalty, there are no minimum royalty or shipped quantity requirements. This software license agreement is in addition to the technology license agreement that Wave and WEC are a party to and royalties under this new software license agreement are in addition to the previously existing technology license agreement.

Wave also continues to work with all of its partners and customers to introduce and promote its existing software products and new software products which are under development, in an effort to expand the market for TPM-based secure computing and thereby increase its market share and revenues. However, it should be noted that because of the early stage of Wave’s market and other factors, a high level of uncertainty exists with respect to the ability to forecast future revenues. Although there has been a substantial increase in the volume of shipments of TPM chips, TPM hardware security that meets the TCG industry standard, which our business model depends upon, is still a new, developing category within the computer security market, the ultimate size of this market and the timeframe for its development are unknown and difficult to predict.

The license and distribution agreements referred to above began to generate royalty revenue in the quarter ended June 30, 2006. The aggregate amount of royalty revenue from these arrangements for 2006 and future years may be material. We have begun to receive payments of these additional royalties in the second quarter of 2006 and expect to continue to generate cash flow from these agreements as long as the agreements remain in effect and our software continues to ship with these products.

As stated previously, Wavexpress currently has one contract with a customer for its broadband media distribution services. Given that this is a new type of service, it is difficult to predict the subscription levels and, therefore, the revenue that will be generated from these contracts. In addition, Wavexpress has a number of customer prospects with whom it may close business in 2006; however, it is also difficult to predict the number of contracts that it will enter into during the year.

Known trends and uncertainties affecting future cash flows

Because Wave does not have sufficient cash to fund operations for the year ending June 30, 2007 and given that it is unlikely that Wave will generate sufficient revenues to fund its operations over this time period, Wave has been and will continue to be actively engaged in financing activities in order to generate additional funding to cover its operating costs for the year ending June 30, 2007. These activities include the filing of a second $25,000,000 S-3 shelf registration with the SEC on December 16, 2005, which was declared effective on January 13, 2006; the closing of an initial round of financing under this shelf registration on February 16, 2006, for which we received approximately $4,250,000 in net proceeds for the sale of 2,782,866 shares of common stock at $1.605 per share, and the closing of a second round of financing under this shelf registration on May 5, 2006 for which we received approximately $4,548,400 in net proceeds for the sale of 2,012,500 shares of common stock at $2.40 per share. We also received net proceeds of $600,000 after subtracting $25,000 in placement agency fees, for the issuance of 276,620 shares of Class A Common Stock upon the exercise of two warrants that were granted to an investor as part of Wave’s December 5, 2005 financing and February 15, 2006 financing. The warrant issued in connection with the December 5, 2005 financing was exercised for 114,583 shares of Class A Common Stock at an exercise price of $2.40 per share. The warrant issued in connection with the February 15, 2006 financing was exercised for 162,037 shares of Class A Common Stock at an exercise price of $2.16 per share. Also, pursuant to a financing entered into on August 4, 2006 under the same shelf registration statement, we sold 2,336,752 shares of Wave’s Class A common stock at $2.05 per share for gross proceeds of $4,790,342, for which we expect to receive approximately $4,520,800 in net proceeds. In connection with that financing, we also agreed to issue a warrant to the placement agent (as part of the fees paid to the placement agent) that will allow the placement agent to acquire 116,837 shares of Wave Class A common stock for $2.05 per share. The warrant expires on September 3, 2007.

We will be required to sell additional shares of common stock, preferred stock, obtain debt financing or engage in a combination of these financing alternatives, to raise additional capital to continue to fund our operations for the year ending June 30, 2007. The availability and amount of any such financings are unknown at this time. Wave may also be required to reduce expenses which may significantly impede its ability to meet its sales, marketing and development objectives. Given the available cash currently on hand and our expenditure forecast for the next twelve months ending June 30, 2007, we estimate that we will need to generate at least $10,600,000, over and above the $4,520,800 that we expect to receive from the August 4, 2006 sale of common stock, from a combination of revenue growth and additional financing activities, in order to continue as a going concern for the next twelve months ending June 30, 2007.

Other uncertainties that may impact the future business outlook

Uncertainty exists with respect to the legal matters that are currently pending including the formal SEC investigation and the class action securities shareholder lawsuits that have been served on Wave. There is uncertainty as to the amount of legal costs that Wave may incur in addressing these matters. In addition, the extent of any impact due to negative publicity or perceived negative publicity is unknown.

Because the information security services market and the TCG hardware security category, in particular, are in early stages of development, customer requirements may change and new competitive pressures can emerge, which could require a shift in product development and/or market strategy. Should such shifts occur, it may require development, marketing and sales strategies to re-start or expand, which would likely increase operating costs, requiring additional capital. Such shifts have occurred several times throughout Wave’s history and have required significant changes in strategy and business plan.

Furthermore, the achievement of sufficient revenue is dependent upon continued significant expenditures, which will likely be required for research and development and sales and marketing beyond June 30, 2007 to increase market awareness. Therefore, if Wave is not able to begin to generate significant revenues by June 30, 2007 to cover its operating costs, it will need to generate capital from other sources, including raising funds through either issuing additional common stock, preferred stock and/or debt to fund its operations beyond June 30, 2007.

Commitments

Wave has no significant long-term contractual obligations other than with respect to operating leases for its facilities, which are listed below:

	Within one year		Years two and three		Years four and five		Total
Operating lease commitments	$	603,871	$	555,120	$	85,811	$	1,244,802

Net operating and capital loss carryforwards

As of December 31, 2005, Wave had available net operating and capital loss carryforwards for Federal income tax purposes of approximately $252 million, which expire beginning in 2006 through 2025. Because of the “change in ownership” provisions of the Tax Reform Act of 1986, the utilization our net operating and capital loss carryforwards against taxable income in future periods may be subject to an annual limitation if a cumulative change in ownership of more than 50 percent of Wave occurs within any three-year period. We have made no determination concerning whether there have been such cumulative changes in ownership or the impact on the utilization of the loss carryforwards if such changes have occurred. However, in considering Section 382 of the Internal Revenue Code, we believe that it is likely that such a change in ownership occurred prior to or following the completion of our initial public offering in September 1994 and, potentially, in periods following. As a result, all of the utilization of our net operating losses is likely to be subject to annual limitations.

Going concern opinion

The accompanying consolidated financial statements have been prepared assuming that Wave will continue as a going concern. Wave’s independent auditors, KPMG LLP, have issued a report on Wave’s financial statements as of December 31, 2005, dated March 9, 2006, that includes an explanatory paragraph referring to our significant operating losses and substantial doubt of our ability to continue as a going concern. (See also Note 1 to Wave’s consolidated financial statements.)

Item 3. Quantitative and Qualitative Disclosures about Market Risk

The exposure to market risk associated with interest rate-sensitive instruments is not material. Wave’s cash and cash equivalents consist primarily of money market funds that meet high credit quality standards and the amount of credit exposure to any one issue is limited.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures.

As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of Wave’s management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of Wave’s disclosure and control procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934 (the “Exchange Act”). Based on that evaluation, the CEO and CFO have concluded that Wave’s disclosure controls and procedures were effective as of June 30, 2006 to ensure that information required to be disclosed by Wave in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC rules and forms.

There has been no change in our internal controls over financial reporting that occurred during the period ended June 30, 2006 that has materially affected, or is reasonably likely to materially affect, Wave’s internal controls over financial reporting.

PART II - OTHER INFORMATION

ITEM 1. Legal Proceedings

Securities and Exchange Commission Investigation

On December 17, 2003, Wave received an Order by the Securities and Exchange Commission regarding a formal investigation. The focus of this investigation is on certain public statements made by Wave during and around August 2003, as well as certain trading in Wave’s securities during such time. Wave is cooperating fully with the SEC in this investigation. Wave is unable to predict the outcome of this investigation at this time.

Purported Class Actions

Item 1a. Risk Factors

This report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to certain factors, including those discussed below, and elsewhere in this quarterly report.

We have a history of net losses and expect net losses will continue. If we continue to operate at a loss, our business will not be financially viable.

We have experienced significant losses and negative cash flow from operations since our inception. We have not realized a net operating profit in any quarter since we began our operations,. This is due primarily to the early stage nature of the digital security industry in which we operate. As of June 30, 2006, we have an accumulated deficit of approximately $294.3 million and negative working capital of approximately $119,000. Given the lack of significant sales of our products and services, there is little basis for evaluating the financial viability of our business and our long-term prospects. You should consider our prospects in light of the risks, expenses and difficulties that companies in new and rapidly evolving markets encounter.

To achieve profitability we must, among other things:

• Convince chip, personal computer motherboard, personal computer and computer peripheral manufacturers to license and distribute our products and services and/or make them available to their customers through their sales channels;

• Convince computer end users and enterprise computer users to purchase our upgrade software and server products for trusted computing:

• Convince consumers to choose to order, purchase and accept products using our products and services;

• Continue to maintain the necessary resources, especially talented software programmers;

• Develop relationships with personal computer manufacturers and computer systems integrators to facilitate and to maximize acceptance of our products and services; and

• Generate substantial revenue, complete one or more commercial or strategic transactions or raise additional capital to support our operations until we can generate sufficient revenues and cash flows.

If we do not succeed in these objectives, we will not generate revenues; hence, our business will not be sustainable.

We may not be able to fund our operations and continue as a going concern.

Since we began our operations, we have incurred net losses and experienced significant negative cash flow from operations. This is due to the early stage nature of market development for our products and services and the digital security industry as a whole. Wave expects to continue to incur substantial additional expenses associated with continued research and development and business development activities that will be necessary to commercialize our technology. This will likely result in significant losses for the foreseeable future. Considering our current cash balance including net proceeds of approximately $4,520,800 that we received from the sale of 2,336,752 shares of common stock on August 4, 2006, and Wave’s projected operating cash requirements, we anticipate that our existing capital resources will be adequate to satisfy our cash flow requirements into November of 2006. In order to fund our business through November of 2006 and beyond, it will be necessary for us to generate substantial additional revenue, complete one or more commercial or strategic transactions or raise additional capital. Wave is uncertain as to the availability of financing from other sources to fund any cash deficiencies. Even if we are successful in raising additional capital, uncertainty with respect to Wave’s viability will continue until we are successful in achieving our objectives. Furthermore, although we may be successful at achieving our business objectives, a positive cash flow from operations may not ultimately be realized unless we are able to sell our products and services at a profit. Given the early stage nature of the markets for our products and services, considerable uncertainty exists as to whether or not Wave’s business model is viable.

We may be unable to raise the $10.6 million of additional cash flow, which is necessary to continue as a going concern for the next twelve months.

Based upon our current expense forecast, we estimate that our current available capital, including net proceeds of approximately $4,520,800 that we received from the sale of 2,336,752 shares of common stock on August 4, 2006 is sufficient to fund Wave into November of 2006. In addition to our efforts to begin to generate revenue sufficient to fund our operations, or complete one or more commercial or strategic transactions, Wave is evaluating additional financing options to generate additional capital in order to continue as a going concern, to capitalize on business opportunities and market conditions and to insure the continued development of our technology, products and services. We estimate, based upon our current forecasts that we will need to generate approximately $10.6 million, in addition to the $4,520,800 in proceeds referred to above, from a combination of revenue growth, commercial or strategic transactions and/or additional financings, to continue as a going concern for the twelve months ending June 30, 2007. We expect we will be required to generate a significant portion of this cash through additional financings in the form of sales of securities pursuant to a shelf registration statement filed with the SEC on December 16, 2005, which was declared effective on January 13, 2006. We do not know if additional financing will be available or that, if available, it will be available on favorable terms. If we issue additional shares of our stock, our stockholders’ ownership will be diluted, or the shares issued may have rights, preferences or

privileges senior to those of our common stock. In addition, if we pursue debt financing we may be required to pay interest costs. The failure to generate sufficient cash flow to fund our forecasted expenditures would require us to reduce our cash burn rate which would in turn impede our ability to achieve our business objectives. Furthermore, if we are not successful in generating sufficient cash flow or obtaining additional funding, we will be unable to continue our operations, develop or enhance our products, take advantage of future opportunities, respond to competitive pressures and continue as a going concern.

We may be unable to remain listed on The Nasdaq Global Market or The Nasdaq Capital Market.

On October 26, 2005, we received notification from The Nasdaq Stock Market indicating that for the prior 30 consecutive business days, the bid price of our common stock has closed below the minimum $1.00 per share requirement for continued inclusion under Marketplace Rule 4450(b)(4) (the “Rule”). In accordance with Marketplace Rule 4450(e)(2), we were provided 180 calendar days, until April 24, 2006, to regain compliance by having our shares close above $1.00 for a minimum of 10 consecutive trading days. On April 25, 2006, we received written notification from The Nasdaq Stock Market indicating that the Company failed to regain compliance with the $1.00 per share minimum bid requirement for continued inclusion on The Nasdaq National Global under Nasdaq Marketplace Rule 4450(b)(4) (the “Rule”). Under the Nasdaq rules, we requested an appeal hearing before the Listings Qualifications Panel (the “Panel”).

On July 11, 2006, we received notification that the Panel granted our request for continued listing on The Nasdaq Global Market subject to certain conditions. The Panel’s decision is contingent, among other things, on our implementation of a reverse stock split to be effected for purposes of regaining compliance with the $1 per share minimum bid requirement. Additionally, our minimum closing bid price must be at least $1 for a minimum period of 10 consecutive trading days. The Panel has reserved the right to extend the period of consecutive trading days or impose other conditions if, during the 10 consecutive trading day period the Panel determines that such conditions are required to demonstrate that we are able to maintain long term compliance the minimum bid price and other listing requirements. The Panel has also reserved the right to reconsider the terms of the relief described above based on other developments that would make continued listing inadvisable or unwarranted. At a special meeting held on July 24, 2006, our stockholders approved the implementation by the board of a reverse stock split of our common stock. On July 24, 2006, the Board approved and implemented a 1-for-3 reverse split of our common stock. As of the filing date for this quarterly report, our minimum closing bid price has remained above $1 (since the beginning of the 10 consecutive trading day period designated by the panel).

We may lose the appeal and be de-listed from the Nasdaq Global Market. In such event we will alternatively apply to be listed on The Nasdaq Capital Market as long as we meet the applicable listing requirements of that market at that time. If our appeal is successful with the Nasdaq Global Market, or if we make a successful application for listing on the Nasdaq Capital Market, we may not continue to meet the listing requirements of such market thereafter and may be de-listed from such market.

Our market is in the early stage of development so we are unable to accurately ascertain the size and growth potential for revenue in such a market.

The market for our products and services is still developing and is continually evolving. As a result, substantial uncertainty exists with respect to the size of the market for these products and the level of capital that will be required to meet the evolving technical requirements of the marketplace.

Wave’s business model relies on an assumed market of tens of millions of units shipping with built-in security hardware. Because this market remains in the early stage of development, there is significant uncertainty with respect to the validity of the future size of the market. If the market for computer systems that utilize our products and services does not grow to the extent necessary for us to realize our business plan, we may not be successful.

As this early stage market develops and evolves, significant capital will likely be required to fund the resources needed to meet the changing technological demands of the marketplace. There is uncertainty with respect to the level of capital that may be required to meet these changing technological demands. If the

amount of capital resources needed exceeds our ability to obtain such capital, we may not be a viable enterprise.

Wave is not established in the industry so we may not be accepted as a supplier or service provider to the market.

Wave’s offering represents a highly complex architecture designed to solve many of the security issues currently present with computer systems, such as identity theft, fraudulent transactions, virus attacks, unauthorized access to restricted networks and other security problems that users of computer systems generally encounter. We are uncertain as to whether the marketplace will accept our solution to these security problems. We will not be successful if the market does not accept the value proposition that we perceive to be present in our products and services.

Although Wave has expended considerable resources in developing technology and products that utilize our technology and in business development activities in an attempt to drive the development of the hardware security market, we do not have a track record as a substantial supplier or service provider to consumers of computer systems. Therefore, uncertainty remains as to whether we will be accepted as a supplier to the enterprise and consumer markets, which will likely be necessary for us to be a successful commercial enterprise.

Our products have not been accepted as industry standards, which may slow their sales growth.

We believe platforms adopting integrated hardware security into the PC will become a significant standard feature in the overall PC marketplace. However, our technologies have not been accepted as industry standards. Standards for trusted computing are still evolving. To be successful, we must obtain acceptance of our technologies as industry standards, modify our products and services to meet whatever industry standards ultimately develop, or adapt our products to be complementary to whatever these standards become. If we fail to do any of these, we will not be successful in commercializing our technology; and therefore, we will not generate sales to fund our operations and develop into a self-sustaining, profitable business.

If we do not keep up with technological changes, our product development and business growth will suffer.

Because the market in which we operate is characterized by rapidly changing technology, changes in customer requirements, frequent new products, service introductions and enhancements, and emerging industry standards, our success will depend, among other things, upon our ability to improve our products, develop and introduce new products and services that keep pace with technological developments, remain compatible with changing computer system platforms, respond to evolving customer requirements and achieve market acceptance on a timely and cost effective basis. If we do not identify, develop, manufacture, market and support new products and deploy new services effectively and timely, our business will not grow, our financial results will suffer, and we may not have the ability to remain in business.

We encounter risks relating to security, system disruptions and computer infrastructure that could compromise our digital content.

Although we have implemented in our products various security mechanisms, our products and services may nevertheless be vulnerable to break-ins, piracy and similar disruptive problems caused by Internet users. Any of these disruptions would harm our business. Advances in computer capabilities, new discoveries in the field of security, or other developments may result in a compromise or breach of the technology we use to protect products and information in electronic form. Computer break-ins and other disruptions would jeopardize the security of information stored in and transmitted through the computer systems of users of our products, which may result in significant liability to us and may also deter potential customers.

A party who is able to circumvent our security measures could misappropriate proprietary electronic content or cause interruptions in our operations and those of our strategic partners. We may be required to expend significant capital and other resources to protect against security breaches or to alleviate problems

caused by breaches. Our attempts to implement contracts that limit our liability to our customers, including liability arising from a failure of security features contained in our products and services, may not be enforceable. We currently do not have product liability insurance to protect against these risks.

Competition and competing technologies may render some or all of our products non-competitive or obsolete.

An increasing number of market entrants have introduced or are developing products and services that compete with Wave’s. Our competitors may be able to develop products and services that are more attractive to customers than our products and services. Many of our competitors and potential competitors have substantially greater financial, technical and marketing resources than we have. Also, many current and potential competitors have greater name recognition and larger customer bases that could be leveraged to enable them to gain market share or product acceptance to our detriment. Wave’s potential competitors include security solutions providers such as RSA Security, Inc., Symantec, Computer Associates, Verisign, Inc., Entrust, Inc., Utimaco, Safenet and major systems integrators such as IBM, HP and EDS. In addition, Wave competes with other client security applications companies that have developed or are developing trusted computing applications, including Softex, Phoenix, Infineon and Microsoft.

Other companies have developed or are developing technologies that are, or may become, the basis for competitive products in the field of security and electronic content distribution. Some of those technologies may have an approach or means of processing that is entirely different from ours. Existing or new competitors may develop products that are superior to ours or that otherwise achieve greater market acceptance than ours. Due to Wave’s early stage, and lower relative name recognition compared to many of our competitors and potential competitors, our competitive position in the marketplace is vulnerable.

We have a high dependence on relationships with strategic partners that must continue or our ability to successfully produce and market our products will be impaired.

Due in large part to Wave’s early stage and lower name recognition, we depend upon strategic partners such as large, well established personal computer and semiconductor manufacturers and computer systems’ integrators to adopt our products and services within the Trusted Computing marketplace. These companies may choose not to use our products and could develop or market products or technologies that compete directly with us. We cannot predict whether these third parties will commit the resources necessary to achieve broad-based commercial acceptance of our technology. Any delay in the use of our technology by these partners could impede or prohibit the commercial acceptance of our products. Although we have established some binding commitments from some of our strategic partners, there can be no assurance that we will be able to enter into additional definitive agreements or that the terms of such agreements will be satisfactory. It will be necessary for Wave to expand upon our current business relationships with our partners, or form new ones, in order to sell more products and services for Wave to become a viable, self-sufficient enterprise.

Product defects or development delays may limit our ability to sell our products.

We may experience delays in the development of our new products and services and the added features and functionality to our existing products and services that our customers and prospective customers are demanding. If we are unable to successfully develop products that contain the features and functionality being demanded by these customers and prospective customers in a timely manner, we may lose business to our competitors. In addition, despite testing by us and potential customers, it is possible that our products may nevertheless contain defects. Development delays or defects could have a material adverse effect on our business if such defects and delays result in our inability to meet the market’s demand.

If we lose our key personnel, or fail to attract and retain additional personnel, we will be unable to continue to develop our products and technology.

We believe that our future success depends upon the continued service of our key technical and management personnel and on our ability to attract and retain highly skilled technical, management, sales and marketing personnel. Our industry is characterized by a high level of employee mobility and aggressive recruiting of skilled personnel. There can be no assurance that our current employees will continue to work

for us or that we will be able to hire any additional personnel necessary for our growth. Our future success also depends on our continuing ability to identify, hire, train and retain other highly qualified technical and managerial personnel. Competition for these employees can be intense. We may not be able to attract, assimilate or retain qualified technical and managerial personnel in the future, and the failure of us to do so would have a material adverse effect on our business.

We have a limited ability to protect our intellectual property rights and others could infringe on or misappropriate our proprietary rights.

Our success depends, in part, on our ability to enjoy or obtain protection for our products and technologies under United States and foreign patent laws, copyright laws and other intellectual property laws and to preserve our trade secrets. We cannot assure you that any patent owned or licensed by us will provide us with adequate protection or will not be challenged, invalidated, infringed or circumvented.

We rely on trade secrets and proprietary know-how, which we protect, in part, by confidentiality agreements with our employees and contract partners. However, our confidentiality agreements may be breached, and we may not have adequate remedies for these breaches. Our trade secrets may also otherwise become known or be independently discovered by competitors. We also rely on intellectual property laws to prevent the unauthorized duplication of our software and hardware products. While we have and will continue to protect our software and our patented technology, intellectual property laws may not adequately protect our technology. We have registered trademark and service mark registrations with the United States Patent and Trademark Office for the marks WaveMeter and WaveNet, EMBASSY, Second Shift (the Wave juggler logo), WaveDirect and Charity Wave. Wave intends to apply for additional name and logo marks in the United States and foreign jurisdictions, as appropriate, but we cannot assure you that federal registration of any of these trademarks will be granted.

Regulation of international transactions may limit our ability to sell our products in foreign markets.

Most of our software products are controlled under various United States export control laws and regulations and may require export licenses for certain exports of the products and components outside of the United States and Canada. With respect to our EMBASSY Trust Suite software applications, we have applied for and received export classifications that allow us to export our products, without a license and with no restrictions, to any country throughout the world with the exception of Cuba, Iran, Iraq, Libya, North Korea, Sudan and Syria.

We believe the export classifications that we have received for our software products allow us to sell our products internationally in an effective, competitively advantageous manner. Enhancements to existing products may, and new products, including the EMBASSY Trust Server applications will, be subject to reviews by the BXA to determine what export classification they will receive. Some of our partners demand that our products be allowed to be exported without restrictions and/or reporting requirements. Current export regulations have, in part, allowed us to receive the desired classification without undue cost or effort. However, the export regulations may be modified at any time. Currently, we are allowed to export the products for which we’ve received classification, in an unrestricted manner without a license. However, modifications to the export regulations could prevent us from exporting our existing and future products in an unrestricted manner without a license. Such modifications could also make it more difficult to receive the desired classification. If export regulations were to be modified in such a way, we may be put at a competitive disadvantage with respect to selling our products internationally.

In addition, import and export regulations of encryption/decryption technology vary from country to country. We may be subject to different statutory or regulatory controls in different foreign jurisdictions, and as such, our technology may not be permitted in these foreign jurisdictions. Violations of foreign regulations or regulation of international transactions could prevent us from being able to sell our products in international markets. Our success depends in large part to having access to international markets.

Our stock price is volatile.

The price of our Class A common stock has been and likely will continue to be subject to wide fluctuations in response to a number of events and factors, such as:

• quarterly variations in operating results;

• announcements of technological innovations, new products, acquisitions, capital commitments or strategic alliances by us or our competitors;

• the operating and stock price performance of other companies that investors may deem comparable to us; and

• news reports relating to trends in our markets.

In addition, the stock market in general, and the market prices for technology-related companies in particular, have experienced significant price and volume fluctuations. These broad market fluctuations may adversely affect the market price of our Class A common stock or any of our other securities for which a market develops, regardless of our operating performance. Securities class action litigation has often been instituted against companies that have experienced periods of volatility in the market price for their securities. A settlement of a Class action lawsuit against us is currently pending (See “Item 1. Legal Proceeding” above); and it is possible that we could become the target of additional litigation of this kind that would require substantial management attention and expense. The diversion of management’s attention and capital resources could have a material adverse affect on our business. In addition, any negative publicity or perceived negative publicity of any such litigation could have an adverse impact on our business.

We may be subject to conflicts of interest that could adversely slow our corporate governance process.

Our Board of Directors does not include any representatives of our strategic partners. However, our Board of Directors has included in the past, and may include in the future, representatives of our strategic partners. It is possible that those corporations may be competing against us, or each other, directly or indirectly. A director who also represents another company may voluntarily abstain from voting on matters, where there could be conflicts of interest. Even if such a director does abstain, his presence on the Board could affect the process or the results of the Board’s deliberations. We have adopted no policies or procedures to reduce or avoid such conflicts. If such conflicts of interest arise, they may have a materially adverse effect on our business.

Governmental regulation may slow our growth and decrease our profitability.

There are currently few laws or regulations that apply directly to the Internet. Because our business is dependent in significant respect on the Internet, the adoption of new local, state, national or international laws or regulations may decrease the growth of Internet usage or the acceptance of Internet commerce, which could, in turn, decrease the demand for our products and services and increase our costs or otherwise have a material adverse effect on our business.

Tax authorities in a number of states are currently reviewing the appropriate tax treatment of companies engaged in Internet commerce. New state tax regulations may subject us to additional state sales, use and income taxes.

If we make any acquisitions, we will incur a variety of costs and may never realize the anticipated benefits.

If appropriate opportunities become available, we may attempt to acquire businesses, technologies, services or products that we believe are a strategic fit with our business. We currently have no commitments or agreements with respect to any material acquisitions. If we do undertake any transaction of this sort, the process of integrating an acquired business, technology, service or product may result in operating difficulties and expenditures and may absorb significant management attention that would otherwise be available for ongoing development of our business. Moreover, we may never realize the anticipated

benefits of any acquisition. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities and/or amortization expenses related to certain intangible assets and increased operating expenses, which could adversely affect our results of operations and financial condition.

A formal investigation by the Securities and Exchange Commission could affect our operations.

The SEC has commenced a formal investigation into certain matters relating to Wave. The SEC investigative order relates to certain public statements made by Wave during and around August 2003, as well as certain trading in Wave’s securities during such time. The SEC has not concluded that there has been any wrongdoing and Wave is cooperating fully with the SEC on this matter. An adverse resolution of the investigation may have a negative effect on our financial condition and operating results.

Shareholder derivative demand letters could affect our operations.

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

On July 24, 2006, Wave held its Annual Meeting of shareholders. At the Annual Meeting, the shareholders voted on the following matter:

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

DIRECTOR	FOR	WITHHELD
John E. Bagalay, Jr.	101,327,044	1,514,955
Nolan Bushnell	101,353,370	1,480,600
George Gilder	101,591,544	1,250,455
John E. McConnaughy, Jr.	101,359,037	1,482,962
Steven Sprague	101,484,744	1,357,255

Also on July 24, 2006, Wave held a Special meeting of shareholders. At the July 24, Special meeting of shareholders, the shareholders voted on the following matter:

To approve a series of amendments to the Company’s Restated Certificate of Incorporation to effect a reverse stock split of our Class A Common Stock and Class B Common Stock whereby, at the discretion of our board of directors, each outstanding 2, 3 or 4 shares of the Company’s Class A Common Stock and Class B Common Stock, respectively, would be combined into and become one share of the Company’s Class A Common Stock or Class B Common Stock, as applicable. If approved, the Board of Directors will have the discretion to effect one of such Proposed Amendments and abandon the other Proposed Amendments or to abandon of all of the Proposed Amendments as permitted under Section 242(c) of the Delaware General Corporation Law. The proposal was adopted with the following results: 99,267,820 votes for, 6,203,680 votes against and 54,733 votes abstained.

The share votes reported in this Item 4 are presented without giving effect to the subsequent 3-to-1 reverse stock split implemented by the Company at the close of business on July 25, 2006.

Item 6 Exhibits

(a) Exhibits

Exhibit No.		Description of Exhibit
3.1	—	Restated Certificate of Incorporation, as Amended
31.1	—	Certification of the Chief Executive Officer pursuant to Rule 13a-14a, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	—	Certification of the Chief Financial Officer pursuant to Rule 13a-14a, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	—	Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18.U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated:	August 9, 2006

		WAVE SYSTEMS CORP.
		(Registrant)


		By:	/s/ Steven K. Sprague
		Name: Steven K. Sprague
		Title: President and Chief Executive Officer


		By:	/s/ Gerard T. Feeney
		Name: Gerard T. Feeney
		Title: Chief Financial Officer

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Wave Systems (WAVX) Inactive 10-Q2006 Q2 Quarterly report

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