Wave Systems (WAVX) 10-Q 2008 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2008
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                               

Commission File Number 000-24752

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)

Registrant’s telephone number, including area code:

(413) 243-1600

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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o	Accelerated filer x
Non-accelerated filer o	Smaller reporting company o
(Do not check if a smaller reporting company)

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 November 3, 2008: 58,527,767 shares of Class A Common Stock and 38,232 shares of Class B Common Stock.

Wave Systems Corp. and Subsidiaries

Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2008

Index

		PAGE NO.
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	Consolidated Balance Sheets at September 30, 2008 and December 31, 2007	3
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2008 and 2007	4
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007	5
	Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)	6
	Notes to Unaudited Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24
Item 4.	Controls and Procedures	24
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	25
Item 1A.	Risk Factors	25
Item 6.	Exhibits	31

2

PART I -FINANCIAL INFORMATION

Item 1. Financial Statements

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Balance Sheets

(Unaudited)

	September 30,			December 31,
	2008			2007
Assets
Current assets:
Cash and cash equivalents	$	696,847		$	3,714,030
Accounts receivable, net of allowance for doubtful accounts of $-0- at September 30, 2008 and December 31, 2007	933,389			1,165,385
Prepaid expenses	255,366			339,342
Total current assets	1,885,602			5,218,757
Property and equipment, net	961,346			682,512
Other assets	138,064			136,587
Total Assets	2,985,012			6,037,856
Liabilities and Stockholders’ Equity (Deficit)
Current liabilities:
Accounts payable and accrued expenses	6,604,002			3,253,320
Current portion of capital lease payable	65,039			—
Deferred revenue	1,050,560			289,025
Total current liabilities	7,719,601			3,542,345
Long-term portion of capital lease payable	260,101			—
Total liabilities	7,979,702			3,542,345
Stockholders’ Equity (Deficit):
8% Series I Preferred stock, $.01 par value. Authorized 2,000 shares; 220 shares issued and outstanding at liquidation preference in 2008 and -0- in 2007	2			—
Common stock, $.01 par value. Authorized 150,000,000 shares as Class A; 58,527,767 shares issued and outstanding in 2008 and 49,744,327 in 2007	585,278			497,443
Common stock, $.01 par value. Authorized 13,000,000 shares as Class B; 38,232 shares issued and outstanding in 2008 and 2007	382			382
Capital in excess of par value	335,157,973			325,481,336
Accumulated deficit	(340,738,325		)	(323,483,650		)
Total Stockholders’ Equity (Deficit)	(4,994,690		)	2,495,511
Total Liabilities and Stockholders’ Equity	$	2,985,012		$	6,037,856

See accompanying notes to unaudited consolidated financial statements.

3

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Statements of Operations

(Unaudited)

	Three months ended						Nine months ended
	September 30, 2008			September 30, 2007			September 30, 2008			September 30, 2007
Net revenues:
Licensing	$	1,821,225		$	1,716,878		$	5,442,830		$	4,353,815
Services	13,482			17,371			76,249			77,826
Total net revenues	1,834,707			1,734,249			5,519,079			4,431,641
Cost of sales:
Licensing	198,354			199,104			567,222			558,669
Services	8,614			11,184			56,797			21,393
Total cost of sales	206,968			210,288			624,019			580,062
Gross profit	1,627,739			1,523,961			4,895,060			3,851,579
Operating expenses:
Selling, general, and administrative	4,048,641			3,707,498			12,589,387			11,093,101
Research and development	3,177,408			2,724,857			9,576,213			7,687,312
Total operating expenses	7,226,049			6,432,355			22,165,600			18,780,413
Operating loss	(5,598,310		)	(4,908,394		)	(17,270,540		)	(14,928,834		)
Other income (expense):
Interest income	1,395			130,694			23,682			264,840
Interest expense	(7,817		)	—			(7,817		)	—
Total other income (expense)	(6,422		)	130,694			15,865			264,840
Net loss	$	(5,604,732	)	$	(4,777,700	)	$	(17,254,675	)	$	(14,663,994	)
Loss per common share – basic and diluted	$	(0.10	)	$	(0.10	)	$	(0.32	)	$	(0.32	)
Weighted average number of common shares outstanding during the period	57,896,307			49,736,556			54,261,426			45,636,775

See accompanying notes to unaudited consolidated financial statements.

4

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

	Nine months ended
	September 30,			September 30,
	2008			2007
Cash flows from operating activities:
Net loss	$	(17,254,675	)	$	(14,663,994	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	279,328			241,050
Compensation associated with issuance of stock options	1,706,248			1,342,627
Changes in assets and liabilities:
Decrease (increase) in accounts receivable	231,996			(717,217		)
Decrease (increase) in prepaid expenses	83,976			(246,288		)
Increase in other assets	(1,477		)	(3,029		)
Increase (decrease) in accounts payable and accrued expenses	3,350,682			(217,309		)
Increase in deferred revenue	761,535			73,793
Net cash used in operating activities	(10,842,387		)	(14,190,367		)
Cash flows from investing activities:
Acquisition of property and equipment	(558,162		)	(426,234		)
Net cash used in investing activities	(558,162		)	(426,234		)
Cash flows from financing activities:
Proceeds from capital lease obligation	335,797			—
Payments on capital lease obligation	(10,657		)	—
Net proceeds from issuance of preferred stock	859,970			—
Net proceeds from issuance of common stock	7,198,256			14,404,811
Net cash provided by financing activities	8,383,366			14,404,811
Net decrease in cash and cash equivalents	(3,017,183		)	(211,790		)
Cash and cash equivalents at beginning of period	3,714,030			7,965,994
Cash and cash equivalents at end of period	$	696,847		$	7,754,204

See accompanying notes to unaudited consolidated financial statements.

5

WAVE SYSTEMS CORP. AND SUBSIDIARIES

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

(Unaudited)

	Series I			Class A			Class B
	Preferred Stock			Common Stock			Common Stock			Capital in Excess			Accumulated
	Shares	Amount		Shares	Amount		Shares	Amount		of Par Value			Deficit			Total
Balance at December 31, 2007	—	$	—	49,744,327	$	497,443	38,232	$	382	$	325,481,336		$	(323,483,650	)	$	2,495,511
Net loss and comprehensive loss	—	—		—	—		—	—		—			(17,254,675		)	(17,254,675		)
Issuance of Class A Common at $1.10 per share, less issuance cost of $270,959	—	—		3,173,500	31,735		—	—		3,188,156			—			3,219,891
Issuance of Class A Common at $0.80 per share, less issuance cost of $138,180	—	—		2,151,250	21,513		—	—		1,561,307			—			1,582,820
Issuance of Class A Common Stock pursuant to the Wave Employee Stock Purchase Plan at $0.8925	—	—		209,857	2,098		—	—		185,199			—			187,297
Issuance of Class A Common at $0.85 per share, less issuance cost of $131,793	—	—		1,880,500	18,805		—	—		1,447,827			—			1,466,632
Issuance of Class A Common at $0.60 per share, less issuance cost of $79,330	—	—		1,368,333	13,684		—	—		727,986			—			741,670
Issuance of 8% Series I Preferred Stock at $4,400 per share less issuance costs of $78,030	172	2		—	—		—	—		678,768			—			678,770
Issuance of 8% Series I Preferred Stock at $4,400 per share less issuance costs of $30,000	48	—		—	—		—	—		181,200			—			181,200
Cash paid for fractional shares	—	—		—	—		—	—		(54		)	—			(54		)
Stock-based compensation	—	—		—	—		—	—		1,706,248			—			1,706,248
Balance at September 30, 2008	220	$	2	58,527,767	$	585,278	38,232	$	382	$	335,157,973		$	(340,738,325	)	$	(4,994,690	)

See accompanying notes to unaudited consolidated financial statements.

6

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

September 30, 2008 and 2007

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the financial position of Wave Systems Corp. as of September 30, 2008 and December 31, 2007, its results of operations for the three-month and nine-month periods ended September 30, 2008 and 2007, and cash flows for the nine-month periods ended September 30, 2008 and 2007.  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 U.S. generally accepted accounting principles 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, 2007, included in its Form 10-K filed on March 17, 2008.  The results of operations for the three-month and nine-month periods ended September 30, 2008 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.

1.     Liquidity

The accompanying consolidated financial statements have been prepared assuming that Wave will continue as a going concern.  Wave has incurred substantial operating losses since its inception, and as of September 30, 2008, has an accumulated deficit of $340,738,325.  Wave is expecting to incur an operating loss for the calendar year 2008.  As of September 30, 2008, Wave had negative working capital of $5,833,999.

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 September 30, 2009.

Because Wave does not have sufficient cash to fund operations for the twelve-months ending September 30, 2009; and given the uncertainties described herein with respect to Wave’s revenue outlook, 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 twelve-months ending September 30, 2009.

These activities have included the sale of 1,880,500 shares of common stock, on June 30, 2008, at $0.85 per share for gross proceeds of $1,598,425.  Wave realized net proceeds, in early July 2008, of approximately $1,467,000 after deducting the placement agent fees of $95,906 and additional legal and other fees associated with the issuance of these securities which totaled approximately $36,000.

On August 11, 2008, Wave sold and issued 1,368,333 shares of Class A common stock for an aggregate purchase price of $821,000.  These shares were priced at $0.60 per share.  Wave realized net proceeds of approximately $742,000 after deducting the placement agent fees of $49,260 and additional legal and other fees associated with the issuance of these securities which totaled approximately $30,000.

On September 11, 2008, Wave sold and issued 172 shares of newly designated 8% Series I Convertible Preferred Stock, par value $.01 per share (“Series I Preferred Stock”), for an aggregate purchase price of

7

$756,800.  These shares were priced at $4,400 per share.  Wave realized net proceeds of approximately $679,000 after deducting the placement agent fees of $45,408 and additional legal and other fees associated with the issuance of these securities which totaled approximately $33,000.

On September 29, 2008, Wave sold and issued 48 shares of Series I Preferred Stock, for an aggregate purchase price of $211,200.  These shares were priced at $4,400 per share.  Wave realized net proceeds of approximately $181,000 after deducting legal and other fees associated with the issuance of these securities which totaled approximately $30,000.

On October 30, 2008, Wave sold and issued 111 shares of newly designated Series J Convertible Preferred Stock, par value $.01 per share (“Series J Preferred Stock”), for an aggregate purchase price of $721,500.  Each share of Series J Preferred Stock plus the corresponding warrants were priced at $6,500.  Wave realized net proceeds of approximately $648,000 after deducting the placement agent fees of $43,290 and additional legal and other fees associated with the issuance of these securities which totaled approximately $30,000.

Wave 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 twelve-months ending September 30, 2009.

Considering our current cash balance (including the net proceeds from our October 30, 2008 financing described above) and our anticipated cash receipts, Wave projects that it has enough liquid assets to continue operating through November 2008.  Wave estimates that it will need a minimum of approximately $6,400,000 of additional cash from a combination of revenue growth and additional financings, to fund operating expenses and capital expenditures for the twelve-months ending September 30, 2009.

If Wave is not successful in raising the needed capital referred to above, or is not successful in executing its business plan, Wave could be forced to cease operations or merge with or sell its business to another company.   No assurance can be provided that any of these initiatives will be successful.   Due to Wave’s current cash position, its capital needs over the next year and beyond, the fact that Wave has not at this time secured enough financing to fund operations through November 2008 and beyond, and the uncertainty as to whether Wave will achieve its sales forecast for its products and services, substantial doubt exists with respect to Wave’s 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, convertible preferred stock 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 nine-month periods ended September 30, 2008, were approximately 191,000 shares and 202,000 shares, respectively, versus 2,600 shares and 168,000 shares for the three-month and nine-month periods ended September 30, 2007, respectively.  Employee stock options, convertible preferred stock and other stock warrants to purchase a weighted average of approximately 10,300,000 and 9,122,000 shares were outstanding for the three-month and nine-month periods ended September 30, 2008, respectively versus 7,096,000 and 6,239,000 shares of the three-month and nine-month periods ended September 30, 2007, 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.

8

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 September 23, 2008, Wave, Sarnoff Corporation and Wavexpress entered into a Restructuring Agreement and an Amended and Restated Stockholder Agreement whereby, among other things, the parties agreed to terminate the Joint Venture Agreement between the parties, dated October 15, 1999.  Pursuant to the terms of the Restructuring Agreement and the Amended and Restated Stockholder Agreement, among other things, (i) Sarnoff has converted all of its shares of Series A Convertible Preferred Stock, par value $0.0001 per share, of Wavexpress into shares of common stock, par value $0.0001 per share of Wavexpress, (ii) Sarnoff will no longer have the right to designate members of the board of directors of Wavexpress, (iii) Wave will be entitled to designate all of the members of the board of directors of Wavexpress, and (iv) all joint venture and licensing arrangements with Sarnoff have been terminated.

Wave has funded Wavexpress through a series of convertible notes.  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 September 30, 2008, Wave has funded Wavexpress with approximately $44,984,000 in cash, plus approximately $24,791,000 in accrued interest.  Such amounts include approximately $9,500,000 that automatically converted into 1,826,571 additional shares of Wavexpress at an average conversion price of $5.20 per share.  These amounts are eliminated in consolidation.

As of September 30, 2008, Wave owned 97.2% of Wavexpress while Sarnoff owned 1.7% - assuming Wave’s conversion of the notes described above into shares of common stock of Wavexpress.  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 $1,180,000 and $771,000 for the three-month periods ended September 30, 2008 and 2007, respectively, and approximately $2,810,000 and $2,072,000 for the nine-month periods ended September 30, 2008 and 2007, respectively.

4.     Recent Accounting Pronouncements

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles,” (“SFAS No. 162”).  SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements.  SFAS No. 162 will be effective for the Company as of November 15, 2008.  The implementation of this standard is not expected to have material impact on Wave’s consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements.  SFAS 157 provides guidance for using fair value to measure assets and liabilities. The standard establishes a common definition for fair value to be applied to U.S. GAAP requiring the use of fair value, establishes a framework for measuring fair value and expands required disclosures about such fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007; however, FASB Staff Position FAS 157-2 Effective Date of FASB Statement No. 157 delayed the effective date of SFAS 157 for most nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008. The implementation of SFAS 157 for financial assets and financial liabilities, effective January 1, 2008, did not have a material impact on Wave’s consolidated financial statements. Wave is currently evaluating the potential impact of the adoption of SFAS 157 for nonfinancial assets and nonfinancial liabilities on its consolidated financial statements. See Note 10 for additional fair value disclosures.

In January 2008, Wave adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 expands the scope of what entities may carry at fair value by offering an irrevocable option to record many types of financial assets and liabilities at fair value. Period-to-period changes in fair value are recorded in an entity’s income statement.  Wave has not elected the fair value option for eligible items.

9

5.Share-based Compensation

Wave recognized $501,009 and $542,717 of share-based compensation during the three-months ended September 30, 2008 and 2007, respectively, and $1,706,248 and $1,342,627 for the nine-month periods ended September 30, 2008 and 2007, respectively.  During the three-month period ended September 30, 2008, Wave granted 30,600 stock options at a weighted-average estimated fair value of $0.45.  During the three-month period ended September 30, 2007, Wave granted 1,419,400 stock options at a weighted-average estimated fair value of $1.46.

 The following table summarizes the effect of share based compensation in Wave’s statement of operations, for the three-month and nine-month periods ended September 30, 2008 and 2007:

	Three months ended September 30,				Nine months ended September 30,
	2008		2007		2008		2007
Cost of Sales	$	4,957	$	6,244	$	23,851	$	11,731
Selling, General & Administrative	313,636		325,999		1,028,200		871,211
Research & Development	182,416		210,474		654,197		459,685
Total	$	501,009	$	542,717	$	1,706,248	$	1,342,627

6.Income Taxes

Wave has not recorded any income tax expense due to the net loss incurred for all periods presented.  Wave has federal and state net operating loss carryforwards of approximately $278.4 million, which expire beginning in 2008 through 2027.  Wave also has capital loss carryforwards for tax return purposes of approximately $8.6 million, which expire beginning in 2008 through 2010.  Pursuant to Section 382 of the Internal Revenue Code, the annual utilization of Wave’s net operating and capital loss carryforwards may be substantially limited if a cumulative change in ownership of more than 50% occurs within any three-year period.  Wave has not determined 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, Wave believes that it is likely that such a change in ownership has occurred thus raising the likelihood that such net operating and capital loss carryforwards are subject to annual limitations.

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 income.  These items are not reported by segment since they are excluded from the measurement of segment performance reviewed by Gerard T. Feeney, Wave’s chief operating decision maker.

The following sets forth reportable segment data:

10

	Three months ended September 30,						Nine months ended September 30,
	2008			2007			2008			2007
Operating Revenues:
EMBASSY® digital security products and services	$	1,834,707		$	1,734,249		$	5,519,079		$	4,431,641
Wavexpress broadband media distribution	—			—			—			—
Total Operating Revenues	1,834,707			1,734,249			5,519,079			4,431,641
Net Loss:
EMBASSY® digital security products and services	(4,418,691		)	(4,137,050		)	(14,460,877		)	(12,856,951		)
Wavexpress broadband media distribution	(1,179,619		)	(771,344		)	(2,809,663		)	(2,071,883		)
Total Segments Net Loss	(5,598,310		)	(4,908,394		)	(17,270,540		)	(14,928,834		)
Net interest income (expense)	(6,422		)	130,694			15,865			264,840
Net Loss	(5,604,732		)	(4,777,700		)	(17,254,675		)	(14,663,994		)
Depreciation and Amortization Expense:
EMBASSY® digital security products and services	78,707			84,461			229,711			223,980
Wavexpress broadband media distribution	26,583			10,049			49,617			17,070
Total Depreciation and Amortization Expense	105,290			94,510			279,328			241,050
Capital Expenditures:
EMBASSY® digital security products and services	21,726			139,709			123,747			341,226
Wavexpress broadband media distribution	427,055			54,098			434,415			85,008
Total Capital Expenditures	$	448,781		$	193,807		$	558,162		$	426,234

	September 30,		December 31,
	2008		2007
Assets:
EMBASSY® digital security products and services	$	2,435,078	$	5,915,158
Wavexpress broadband media distribution	549,934		122,698
Total Assets	$	2,985,012	$	6,037,856

The following table details Wave’s sales by geographic area for the three and nine-month periods ended September 30, 2008 and 2007.  Geographic area is based on the location of where the products were shipped or services rendered.

	United States of America			Europe			Asia			Total
Three months ended September 30, 2008:
EMBASSY® digital security products and services	$	1,764,131		$	9,313		$	61,263		$	1,834,707
Wavexpress broadband media distribution	—			—			—			—
Total	1,764,131			9,313			61,263			1,834,707
% of Total Revenue	96		%	1		%	3		%	100		%
Three months ended September 30, 2007:
EMBASSY® digital security products and services	$	1,633,037		$	64,625		$	36,587		$	1,734,249
Wavexpress broadband media distribution	—			—			—			—
Total	1,633,037			64,625			36,587			1,734,249
% of Total Revenue	94		%	4		%	2		%	100		%
Nine months ended September 30, 2008:
EMBASSY® digital security products and services	$	5,345,930		$	40,200		$	132,949		$	5,519,079
Wavexpress broadband media distribution	—			—			—			—
Total	5,345,930			40,200			132,949			5,519,079
% of Total Revenue	97		%	1		%	2		%	100		%
Nine months ended September 30, 2007:
EMBASSY® digital security products and services	$	4,180,823		$	164,764		$	86,054		$	4,431,641
Wavexpress broadband media distribution	—			—			—			—
Total	4,180,823			164,764			86,054			4,431,641
% of Total Revenue	94		%	4		%	2		%	100		%

11

Substantially all long-lived assets of Wave Systems Corp. are located within the United States of America.

Customers, by segment, from which Wave derived revenue in excess of 10% for the three and nine-month periods ended September 30^th are as follows:

		Three months ended September 30,						Nine months ended September 30,
		2008			2007			2008			2007
Customer	Segment	Revenue						Revenue
Dell, Inc.	EMBASSY®	$	1,548,252		$	1,279,395		$	4,531,447		$	3,229,932
% of Total Revenue		84		%	74		%	82		%	73		%

8.Issuance of Preferred Stock

    On September 11, 2008, Wave entered into subscription agreements, pursuant to which Wave sold and issued 172 shares of newly designated 8% Series I Preferred Stock, par value $.01 (“Series I Preferred Stock”), to certain purchasers for an aggregate purchase price of $756,800.  These shares were priced at $4,400 per share.  Security Research Associates, Inc. (“SRA”) entered into a placement agency agreement with Wave in which they acted as placement agent in connection with this offering.  Wave paid SRA a fee equal to 6.0% of the gross proceeds of this offering.  Additionally, Wave issued a warrant to SRA to purchase up to 103,200 shares of Class A common stock at an exercise price of $0.50 per share.  This warrant expires in September 2011.Wave realized net proceeds of approximately $679,000 after deducting the placement agent fees of $45,408 and additional legal and other fees associated with the issuance of these securities which totaled approximately $33,000.

On September 29, 2008, Wave entered into subscription agreements, pursuant to which Wave sold and issued 48 shares of Series I Preferred Stock, to certain purchasers for an aggregate purchase price of $211,200.  These shares were priced at $4,400 per share.   Wave realized net proceeds of approximately $181,000 after deducting legal and other fees associated with the issuance of these securities which totaled approximately $30,000.

Each share of Series I Preferred Stock issued in connection with these two offerings is convertible into 10,000 shares of Class A common stock at the election of the holder thereof at any time or automatically on the date on which the average closing price per share of Wave common stock for the 15 consecutive trading day period then ended equals or exceeds $1.10.  On liquidation/dissolution, the Series I Preferred Stock will rank senior to the common stock and to any other series of preferred stock that may hereafter be designated by the board of directors as junior to the Series I Preferred Stock.  Dividends will accrue at 8% per annum, payable every six months in either cash or in shares of Wave common stock (at the Company’s election) at a rate equal to $0.44 per share of Wave common stock.  The shares subscribed to on September 29, 2008 and September 11, 2008 were offered and issued pursuant to a shelf registration statement on Form S-3 which was filed by Wave on April 18, 2008 and declared effective by the Commission on June 23, 2008.

12

9.Issuance of Common Stock

On August 11, 2008, Wave entered into subscription agreements, pursuant to which Wave sold and issued 1,368,333 shares of Class A common stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $821,000.  These shares were priced at $0.60 per share.  Securities Research Associates, Inc. (“SRA”) entered into a placement agency agreement with Wave in which they acted as placement agent in connection with the offering.  Wave paid SRA a fee equal to 6.0% of the gross proceeds of this offering.  Wave also issued warrants to the purchasers to purchase up to 342,083 shares of Class A common stock at an exercise price of $0.65 per share.  These warrants expire in August 2011.  Wave also issued a warrant to SRA to purchase up to 82,100 shares of Class A common stock at an exercise price of $0.65 per share.  This warrant expires in August 2011.  Wave realized net proceeds of approximately $742,000 after deducting the placement agent fees of $49,260 and additional legal and other fees associated with the issuance of these securities which totaled approximately $30,000.  The shares subscribed to on August 11, 2008 were offered and issued pursuant to a shelf registration statement on Form S-3 which was filed by Wave on April 18, 2008 and declared effective by the Commission on June 23, 2008.

On June 30, 2008, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 1,880,500 shares of Class A Common Stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $1,598,425.  These shares were priced at $0.85 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 6.0% of the gross proceeds of this offering.  Wave also agreed to issue warrants to the subscribers to purchase up to 470,125 shares of Class A common stock at an exercise price of $0.90 per share.  These warrants expire in June 2011.  Additionally, Wave agreed to issue a warrant to SRA to purchase up to 112,830 shares of Class A common stock at an exercise price of $0.90 per share.  This warrant expires in June 2011.  Wave realized net proceeds, in early July, of approximately $1,467,000 after deducting the placement agent fees of $95,906 and additional legal and other fees associated with the issuance of these securities which totaled approximately $36,000.  The shares subscribed to on June 30, 2008 were issued in early July and offered and issued pursuant to a shelf registration statement on Form S-3 which was filed by Wave on March 20, 2007 and declared effective by the Commission on April 27, 2007.

10.Fair Value Measurement

As of September 30, 2008, Wave’s financial assets that are measured at fair value on a recurring basis are comprised of overnight money market fund investments.  Wave invests excess cash from its operating cash accounts in overnight money market funds and reflects these amounts (approximately $697,000 at September 30, 2008) within cash and cash equivalents on the consolidated balance sheet using quoted prices in active markets for identical assets (Level 1) at a net value of 1:1 for each dollar invested.

11.Subsequent Events

On October 30, 2008, Wave entered into subscription agreements, pursuant to which Wave sold and issued 111 shares of newly designated Series J Convertible Preferred Stock, par value $.01 per share (the “Series J Preferred Stock”), plus warrants to purchase up to 2,220,000 shares of Class A common stock to certain purchasers for an aggregate purchase price of $721,500.  Purchasers paid an amount equal to $6,500 per share of preferred stock and the corresponding warrants.  This is based on a $4,000 per share liquidation value for each share of preferred stock plus an additional $0.125 for each share of common stock issuable upon exercise of the corresponding warrants.  For each share of Series J Preferred Stock purchased, the purchaser received a warrant to purchase 20,000 shares of common stock at an exercise price equal to $.40.  These warrants expire in October 2013.  Each share of Series J Preferred Stock is convertible into 10,000 shares of common stock at the election of the holder thereof at any time or automatically on the date on which the average closing price per share of Wave common stock for the 15 consecutive trading day period then ended equals or exceeds $1.00.  Securities Research Associates, Inc. (“SRA”) entered into a placement agency agreement with Wave in which they acted as placement agent in connection with the offering. On liquidation/dissolution, the Series J Preferred Stock will rank senior to the Series I Preferred Stock, the common stock and to any other series of preferred stock that may hereafter be designated by the board of directors as junior to the Series J Preferred Stock.  Wave paid SRA a fee equal

13

to 6.0% of the gross proceeds of this offering.  Wave also issued a warrant to SRA to purchase up to 66,600 shares of Class A common stock at an exercise price of $0.40 per share.  This warrant expires in October 2011. Wave realized net proceeds of approximately $648,000 after deducting the placement agent fees of $43,290 and additional legal and other fees associated with the issuance of these securities which totaled approximately $30,000.  The shares subscribed to on October 30, 2008 were offered and issued pursuant to a shelf registration statement on Form S-3 which was filed by Wave on April 18, 2008 and declared effective by the Commission on June 23, 2008.

CERTAIN FORWARD-LOOKING INFORMATION:

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

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

Overview

Our Business

Wave Systems Corp. 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”), an industry standards body.  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.

Wave has accepted an invitation from the TCG to assume a permanent seat on its Board of Directors (the “TCG Board”), joining permanent members AMD, HP, IBM, Infineon, Intel, Lenovo, Microsoft, Sun and Seagate Technology.  Wave also agreed to elevate its membership status to the highest level of TCG “Promoter.”  Permanent members of the TCG Board provide guidance to the organization’s work groups in the creation of the specifications to protect PCs and other computing devices from attacks and to help prevent data loss and theft.  Wave’s enhanced membership status allows it to take a more active role in helping to develop, define and promote hardware-enabled trusted computing security technologies, including related hardware building blocks and software interfaces.  Wave is now eligible to serve on and chair the TCG Board, Work Groups and Special Committees; is able to submit revisions and addendum proposals for specifications with design guides; and may review and comment on design guides prior to their adoption.

The current TCG specification recommends a hardware-based trusted computing platform, which is a platform that uses a semiconductor device, known as a Trusted Platform Module (“TPM”) that performs protected activities, including protected storage, platform authentication, protected cryptographic processes and attestable state capabilities to provide the first level of trust for the computing platform (a “Trusted 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.

Management has focused on entering into licensing contracts pursuant to which the OEM licenses our applications and distributes them as part of their offering, paying Wave a royalty for each unit shipped. As of September 30, 2008, Wave has signed such bundling agreements with seven separate OEM partners.  In mid-October 2008, Wave completed a license agreement with Acer, Wave’s eighth OEM partner and the

14

world’s third-largest PC vendor, to bundle Wave EMBASSY® software with Acer’s new Veriton™ 670 business PCs. Shipments are expected to begin by the end 2008. The motherboards on the Acer desktops feature an integrated Trusted Platform Module (iTPM).  Revenue recognized on these contracts for the three-month periods ended September 30, 2008 and 2007 was approximately $1,770,000 and $1,723,000, respectively.  For the nine-month periods ended September 30, 2008 and 2007, revenue recognized on these contracts amounted to approximately $5,288,000 and $4,278,000, respectively.

Management is focused on opportunities for its eSign Transaction Management Suite, also known as eTMS (“eTMS”), 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.  In June 2008, Wave announced that Xerox Mortgage Services added e-signature – a secure and convenient way to complete mortgage loans without having to sign hardcopy documents – with licensing through Wave’s eSign Systems division. Wave’s e-signature capabilities build upon Xerox’s current Web-based BlitzDocs®Blitz technology – providing customers with a comprehensive solution for paperless mortgage transactions.  In mid-October, Wave’s eSign division announced enhancements to its Electronic Transaction Management Suite (eTMS).  Closing documents can now be signed and notarized in a secure environment and the note then registered through the Mortgage Electronic Registry System (MERS®), the industry-endorsed system for electronically tracking mortgage ownership and servicing rights.  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 primarily advertising supported video entertainment services. Wavexpress’ TVTonic service offers hundreds of video feeds, a significant number of which are signed to revenue sharing agreements for ad placements.  The service is 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.  TVTonic is promoted by Microsoft with all installations of their Media Center software.  Media Center is standard with Microsoft Vista Premium and Vista Ultimate, as well as XP Media Center Edition.  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.  Management plans to devote ongoing 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-enabled 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”), Trusted Drive Manager (“TDM”), Document Manager (“DM”), Private Information Manager (“PIM”) 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.  The ESC software was updated to support Seagate’s Momentus 5400 FDE.2 hard drive, the latest version of Seagate’s FDE drives (the “Seagate Trusted Drives”).  Wave’s EMBASSY Trust Suite software for TPM and key management also supports Seagate Trusted Drives.

Data Protection is addressed by the DM, which provides document encryption, decryption and client side storage of documents. The DM, which works with Microsoft Windows, and Microsoft Office, secures documents against unauthorized users and hackers.  Wave’s software is Windows Vista ready and builds upon the operating system’s data protection feature set, providing full-featured EMBASSY solutions for data protection and strong authentication.

15

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.

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 encrypted email.

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 $3.8 million for the twelve-month period ending September 30, 2009.

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 $5.3 million for the twelve-month period ending September 30, 2009.

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 third-party vendors.

16

EMBASSY Remote Administration Server (“ERAS”)

ERAS is a server product that provides centralized management and auditing of Trusted Platform Modules (“TPM”) and Seagate Trusted Hard Drives (“Trusted Drive”).  ERAS is designed to give IT administrators the ability to deploy and remotely manage Trusted Drives and TPM systems.  ERAS will also provide the ability to remotely manage newly available Trusted Drives.  It provides for initialization, pre-boot authentication management, recovery, and repurposing of TPMs and Trusted Drives.  ERAS is designed to provide auditing capabilities that aid in compliance management by allowing for validation of TPM and Trusted Drive security settings, thus allowing IT administrators to assess the risk of whether a lost or compromised PC is adequately secure.  ERAS is designed to facilitate enterprise adoption of TPM and Trusted Drive technology as it provides IT administrators with tools to utilize the security of these devices while reducing deployment and management costs.  In early November 2008, Wave announced the availability of enhanced versions of its EMBASSY Trusted Drive Manager and Remote Administration Server to enable security features on Seagate’s new 7200 and 5400 line of self-encrypting drives, shipped on Dell’s new E-Series notebook PCs. Current planned development costs for this product are expected to be approximately $1.8 million for the twelve-month period ending September 30, 2009.

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.  Wave’s SmartSignature Server, a server-side electronic signature application, 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.  During the fourth quarter of 2007, Wave launched SmartSigning Rooms Version 1.0, which enhances the functionality of the SmartSAFE to enable an organization to offer signers a secure virtual environment to review, annotate and electronically sign documents.  In mid-October 2008, Wave’s eSign division announced enhancements to eTMS.  Closing documents can now be signed and notarized in a secure environment and the note then registered through the Mortgage Electronic Registry System (MERS®), the industry-endorsed system for electronically tracking mortgage ownership and servicing rights.

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 4.0 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 at a lower cost compared to traditional paper-based documentation methods.  SmartSignature Version 3.0 and SmartSAFE Version 4.0 have been completed and Wave has commercially released these products.  Wave will continue to allocate resources toward marketing and sales to promote these products.

Wave’s eTMS, in addition to supporting TPMs, is also being independently marketed in the insurance, mortgage, banking, 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”).  Over the past 24 months, through direct and reseller channels, over 3,000 organizations have used eTMS functionality to automate paper processes.  Some of the flagship organizations that are currently utilizing eTMS include: a la Mode, Ellie Mae, Realtime Solutions Group, Heritage Union, DocuTech, Remark, American Community Life Insurance Company, Trust Company of America, Digital Docs, Compliance Source and others.  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 $330,000 for the twelve-month period ending September 30, 2009.

17

Broadband Media Distribution Services

Wave offers broadband content distribution products and services through Wavexpress, which was a joint venture between Wave and Sarnoff Corporation.  On September 23, 2008, Wave, Sarnoff Corporation and Wavexpress entered into a Restructuring Agreement and an Amended and Restated Stockholder Agreement whereby, among other things, the parties agreed to terminate the Joint Venture Agreement between the parties.  As of September 30, 2008, Wave owned 97.2% of Wavexpress while Sarnoff owned 1.7% (on a fully diluted basis).

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 XP Media Center Edition operating system, as well as the Vista Premium and Vista Ultimate operating systems.  It is also available through Microsoft’s Internet Explorer web browser.

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 futures development expenditures are expected to approximate $1.7 million for the twelve-month period ending September 30, 2009.

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, we believe that 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 a 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, we believe we are distinctively positioned to take advantage of our unique knowledge, significant technology assets and trusted computing intellectual properties.

Hardware-based trusted computing solutions involve a new approach to conducting business and exchanging information using computer systems.  We believe that these solutions will require traditional software-based security to 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.  Our objective is to make our EMBASSY branded products and services the preferred applications and infrastructure for Trusted Platforms.

18

R&D

Wave has realized minimal operating revenues since its inception.  At September 30, 2008, Wave had an accumulated deficit of approximately $340.7 million.  Wave has made a substantial investment in research and development, including approximately $3.2 million and $9.6 million for the three and nine-month periods ended September 30, 2008, respectively, and expects to continue to make substantial investments in its products and technology.  For the years ended December 31, 2007, 2006 and 2005, Wave spent approximately $10.6 million, $8.5 million and $6.9 million, respectively, on research and development activities.

Critical Accounting Policies

Wave’s discussion and analysis of its financial condition and results of operations are based on the Company’s consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. 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 and share based compensation.  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.

A detailed description of the accounting policies deemed critical to the understanding of the consolidated financial statements are included in the notes to Wave’s audited financial statements for the year ended December 31, 2007, included in its Form 10-K filed on March 17, 2008.

Results of Operations

Three-Months Ended September 30, 2008 and 2007

Wave had revenues of $1,834,707 and $1,734,249 for the three-months ended September 30, 2008 and 2007, respectively.  The increase was due primarily to licensing revenues, which increased by $104,347 during the quarter.  This increase was due primarily to a higher volume of software license upgrades. 

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

	2008		2007		Increase			% Change
Licensing	$	1,821,225	$	1,716,878	$	104,347		6	%
Services	13,482		17,371		(3,889		)	(22	)%
Total Net Revenues	$	1,834,707	$	1,734,249	$	100,458		6	%

Cost of sales for the three-months ended September 30, 2008, was $206,968 compared with $210,288 for the same period in 2007.  The change in costs of sales was due to a decrease in customer support costs during the September 30, 2008 quarter versus the prior year.

For the reasons noted above, gross profit for the three-months ended September 30, 2008 and 2007 was $1,627,739 and $1,523,961, respectively.  Wave’s gross profit percentage was 88.7% for the quarter ended September 30, 2008 as compared to 87.9% for the same period in 2007.

Selling, general and administrative (“SG&A”) expenses for the three-months ended September 30, 2008 were $4,048,641, as compared to $3,707,498 for the comparable period of 2007, an increase of approximately 9%.  The increase was primarily due to an increase in telephone expenses – significantly higher bandwidth charges incurred as a result of expanding the broadband infrastructure in order to

19

broadcast the 2008 Olympics - of approximately $296,000 in the quarter ended September 30, 2008 versus the comparable period of 2007.  Included in the SG&A expenses listed above are Wavexpress’ selling, general and administrative expenses, which were $741,030 and $381,807 for the quarters ended September 30, 2008 and 2007, respectively.  This 94% increase was primarily due to the increase in telephone expenses as noted above.

The activities supported by SG&A expenses 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 saleable products and markets for our technology.

Research and development expenses for the three-months ended September 30, 2008 were $3,177,408, as compared to $2,724,857 for the comparable period of 2007, an increase of 17%.  This increase was primarily attributable to increased salaries, fringe and benefit expenditures of approximately $183,000 at Wave and $68,000 at Wavexpress, associated with salary rate increases and headcount additions to accommodate additional research and development efforts, which exceeded those in the three-months ended September 30, 2007.  In addition, product development expenses - primarily language translation costs - increased approximately $163,000 in the quarter ended September 30, 2008 versus the comparable period of 2007.  Wavexpress’ research and development expenditures included in the above were $438,589 and $389,537 for the quarters ended September 30, 2008 and 2007, respectively, for an increase of approximately 13%, due primarily to the increase in salaries, fringe and benefit expenditures noted above.

Interest income for the three-months ended September 30, 2008 was $1,395 as compared to $130,694 for the comparable period of 2007.  The decrease in interest income is primarily attributable to lower average balances of Wave’s money market accounts for the quarter ended September 30, 2008 compared with the same period in 2007.

Interest expense for the three-months ended September 30, 2008 was $7,817 as compared to $-0- for the comparable period of 2007.  The increase is attributable to interest incurred on the new capital lease obligation for equipment acquired for the expansion of the Wavexpress broadband infrastructure and an accrual of interest on the 8% Series I Convertible Preferred Stock issued during the quarter ended September 30, 2008 compared with the same period in 2007.

Due to the reasons set forth above, our net loss to common stockholders for the three-months ended September 30, 2008 was $5,604,732 as compared to $4,777,700 for the comparable period of 2007.

Nine Months Ended September 30, 2008 and 2007

Wave had revenues of $5,519,079 and $4,431,641 for the nine-month period ended September 30, 2008, and 2007, respectively.  The increase was due primarily to licensing revenues, which increased by $1,089,015 during the nine-month period.  This increase was due to a higher volume of shipments of Wave’s OEM customer products, primarily as a result of its OEM relationship with Dell, for which Wave receives royalty income.  Service revenue consists primarily of non-recurring government time and materials contracts.

The table below sets forth the components that make up the revenue for the nine-month period ended September 30:

20

	2008		2007		Increase			% Change
Licensing	$	5,442,830	$	4,353,815	$	1,089,015		25	%
Services	76,249		77,826		(1,577		)	(2	)%
Total Net Revenues	$	5,519,079	$	4,431,641	$	1,087,438		25	%

Cost of sales for the nine-month period ended September 30, 2008, was $624,019, compared with $580,062 for the same period in 2007.  The change in costs of sales was due to an increase in customer support costs in connection with the increased license revenue during the nine-month period ended September 30, 2008 versus the comparable period of 2007.

For the reasons noted above, gross profit for the nine-month period ended September 30, 2008 and 2007 was $4,895,060 and $3,851,579, respectively.  Wave’s gross profit percentage was 88.7% for the nine-months ended September 30, 2008 as compared to 86.9% for the same period in 2007.

SG&A expenses for the nine months ended September 30, 2008, were $12,589,387, as compared to $11,093,101 for the comparable period of 2007, an increase of approximately 13%.  The increase was due mainly to an increase in salaries and related benefits totaling approximately $353,000, associated with salary rate increases and headcount additions to accommodate additional sales, marketing, business development and support activities, which exceeded those in the nine months ended September 30, 2007.  In addition, telephone expenses increased approximately $381,000 over the comparable period of 2007 due to significantly higher bandwidth charges incurred as a result of expanding the broadband infrastructure in order to broadcast the 2008 Olympics.  Also, professional fees increased approximately $362,000 and additional conference and trade show expenses of approximately $123,000 were incurred during the nine-month period ended September 30, 2008 versus the comparable period of 2007.  Stock option expenses also increased by approximately $164,000 during the nine-month period ended September 30, 2008 versus the comparable period of 2007.  Included in the SG&A expenses listed above are Wavexpress’ selling, general and administrative expenses, which were $1,522,089 and $1,027,258 for the nine-month period ended September 30, 2008 and 2007, respectively.  This 48% increase was due primarily to an increase in telephone expenses – primarily increased bandwidth charges incurred in order to expand the broadband infrastructure – of approximately $339,000 during the nine-month period ended September 30, 2008 versus the comparable period of 2007.  Professional fee expenditures increased by approximately $63,000 during the nine-month period ended September 30, 2008 versus the comparable period of 2007.

Research and development expenses for the nine months ended September 30, 2008, were $9,576,213, as compared to $7,687,312 for the comparable period of 2007, an increase of 25%.  This increase was primarily attributable to increased salaries, fringe and benefit expenditures of approximately $1,127,000 at Wave and approximately $221,000 at Wavexpress, associated with salary rate increases and headcount additions to accommodate additional research and development efforts, which exceed those in the nine months ended September 30, 2007.  In addition, product development expenses - primarily language translation costs - increased approximately $252,000 during the nine months ended September 30, 2008 versus the comparable period of 2007.  Also, stock option expenses increased approximately $200,000 and rent and other facilities-related costs increased approximately $82,000 during the nine months ended September 30, 2008 versus the comparable period of 2007.  Wavexpress’ research and development expenditures included in the above were $1,273,179 and $1,044,625 for the nine months ended September 30, 2008 and 2007, respectively, for an increase of approximately 22%, due primarily to the increase in salaries, fringe and benefit expenditures noted above.

Interest income for the nine months ended September 30, 2008, was $23,682 as compared to $264,840 for the comparable period of 2007.  The decrease in interest income is primarily attributable to lower average balances of Wave’s money market accounts for the nine month period ended September 30, 2008 compared with the same period in 2007.

Interest expense for the nine months ended September 30, 2008 was $7,817 as compared to $-0- for the comparable period of 2007.  The increase is attributable to interest incurred on the new capital lease obligation for equipment acquired for the expansion of the Wavexpress broadband infrastructure and an

21

accrual of interest on the 8% Series I Convertible Preferred Stock issued during the nine month period ended September 30, 2008 compared with the same period in 2007.

Due to the reasons set forth above, our net loss to common stockholders for the nine months ended September 30, 2008, was $17,254,675 as compared to $14,663,994 for the comparable period of 2007.

Liquidity and Capital Resources

Wave has experienced net losses and negative cash flow from its operations since its inception, and, as of September 30, 2008, had an accumulated deficit of $340,738,325.  Total stockholders’ deficit as of September 30, 2008 was $4,994,690.  Wave has financed its operations through September 30, 2008 principally through the issuance of Class A and B Common Stock and various series of preferred stock.

Sources and uses of cash

As of September 30, 2008, Wave had $696,847 in cash and cash equivalents.  As of December 31, 2007, Wave had $3,714,030 in cash and cash equivalents.  The decrease in cash and cash equivalents of $3,017,183, resulted from $10,842,387 used in operating activities, $558,162 used in investing activities for the acquisition of capital assets offset by $8,383,366 generated through financing activities, from the sale of 8,783,440 shares of Class A Common Stock, including 209,857 shares sold pursuant to Wave’s Employee Stock Purchase Plan, the sale of 220 shares of Series I Preferred Stock and proceeds from a capital lease obligation.  At September 30, 2008, Wave had negative working capital of $5,833,999.

Liquidity requirements and future sources of capital

Wave estimates that its total expenditures to fund operations for the twelve-months ending September 30, 2009 will be approximately $25,500,000, 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 $696,847 as of September 30, 2008;

·gross margin contribution from sales and licensing of products; and

·additional financings.

Given Wave’s capital requirements for the twelve-month period ending September 30, 2009 as indicated above and Wave’s cash on hand as of September 30, 2008, Wave will be required to raise additional capital to fund its operations.

We may obtain additional funding as needed from further sales of newly issued shares of Class A common stock and/or a series of preferred stock under our $25,000,000 shelf registration statement that we filed on April 18, 2008 that the Securities and Exchange Commission (the “Commission”) declared effective on June 23, 2008. Approximately $22,480,000 in gross proceeds is available under the shelf registration statement filed on April 18, 2008 and declared effective by the Commission on June 23, 2008, which may be utilized for future financings.  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

Wave receives revenue from licensing its EMBASSY Trust Suite and EMBASSY Trust Server Applications software through distribution arrangements with its OEM partners.  The aggregate amount of royalty revenue from these arrangements was a significant contributor to Wave’s revenue growth over the past two years. Revenue from these contracts in future years may also be material.  We 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.  We continued to experience modest upgrade activity during the third quarter of 2008 as enterprise customers began to purchase the packages offered in connection with these

22

distribution agreements.  In addition, Wave received revenues from software development and other services.  Total cash received from all revenue sources for the nine months ended September 30, 2008 was approximately $6,483,000 versus approximately $3,787,000 for the comparable period of 2007.

Wave 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, this remains a new and developing category within the computer security market, and the ultimate size of this market and the timeframe for its development are unknown and difficult to predict.

Known trends and uncertainties affecting future cash flows

Because Wave does not have sufficient cash to fund operations for the twelve-months ending September 30, 2009 and given the uncertainties described above with respect to Wave’s revenue outlook, 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 twelve-months ending September 30, 2009.

It is likely 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 twelve-months ending September 30, 2009.  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 twelve-months ending September 30, 2009, we estimate that we will need to generate at least $6,400,000 from a combination of revenue growth and additional financing activities, in order to continue as a going concern for the twelve-months ending September 30, 2009.

Other uncertainties that may impact the future business outlook

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, requiring 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 to increase market awareness for our products.  Therefore, if Wave is not able to begin to generate significant revenues by September 30, 2009 to cover its operating costs, it will need to generate capital from other sources, including raising funds through the issuance of additional common stock, preferred stock and/or debt to fund its operations beyond September 30, 2009.

Commitments

Wave has a capitalized lease obligation for computer equipment due July 2013 of $325,140 as of September 30, 2008.  The interest rate is 7.7% per annum.  This lease obligation is collateralized by the related assets with a net book value of $352,258 as of September 30, 2008.

Wave has no significant long-term contractual obligations other than with respect to the capitalized lease obligation described above and operating leases for its facilities, which are all listed below:

23

	Within one year		Years two and three		Years four and five		Thereafter		Total
Capital lease commitment	$	65,039	$	126,193	$	133,908	$	—	$	325,140
Operating leases commitments	939,795		1,363,698		755,775		—		3,059,268
Total commitments	$	1,004,834	$	1,489,891	$	889,683	$	—	$	3,384,408

Net operating and capital loss carryforwards

As of December 31, 2007, Wave had available net operating and capital loss carryforwards for federal income tax purposes of approximately $285.0 million, which expire beginning in 2008 through 2027.  Because of the “change in ownership” provisions of the Tax Reform Act of 1986, our net operating and capital loss carryforwards may be subject to an annual limitation on the utilization of these carryforwards against taxable income in future periods if a cumulative change in ownership of more than 50 percent of Wave occurs within any three-year period.  We have made no determination concerning whether there 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 registered public accounting firm, KPMG LLP, has issued a report on Wave’s financial statements as of December 31, 2007, dated March 17, 2008, 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 2 to Wave’s consolidated financial statements included in Wave’s Form 10-Kfor fiscal year 2007.)

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 September 30, 2008 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 Securities and Exchange Commission rules and forms.

There has been no change in our internal controls over financial reporting that occurred during the three-month period ended September 30, 2008 that has materially affected, or is reasonably likely to materially affect, Wave’s internal controls over financial reporting.

24

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

None.

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. Wave’s revenue during the three-months and nine-months ended September 30, 2008 was significantly below operating expenses, as our products have not yet attained widespread commercial acceptance.  This is due primarily to the early stage nature of the digital security industry in which we operate.  As of September 30, 2008, we have an accumulated deficit of approximately $340.7 million and negative working capital of approximately $5,834,000. Given the lack of widespread adoption of the technology for 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 their early stage of development encounter, particularly companies in new and rapidly evolving markets, such as digital security and online commerce.

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, anticipated cash receipts and our projected operating cash requirements, we anticipate that our existing capital resources will be adequate to satisfy our cash flow requirements through November 2008. In order to fund our business beyond November 2008, it will be necessary for us to generate substantial 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 additional cash flow which will be 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 is sufficient to fund Wave through November 2008. 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 current forecasts, we will need to generate at least $6,400,000 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 September 30, 2009.

25

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 Securities and Exchange Commission on April 18, 2008, which was declared effective on June 23, 2008.  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 additional 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.

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

26

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 are subject to risks relating to potential security breaches of our software products.

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. (a division of EMC), 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 are developing trusted computing applications, including Softex Incorporated, Phoenix Technologies Ltd., Infineon Technologies AG 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.

27

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.

28

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 and EMBASSY Trust Server 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 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.  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,

29

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. 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.

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

On July 17, 2008, the Company received notification from the Listing Qualifications division of The NASDAQ Stock Market indicating that the Company’s Class A common stock is subject to potential delisting from The NASDAQ Global Market because the market value of the Company’s common stock was below $50 million for 10 consecutive business days, and, therefore, did not meet the requirement set forth in NASDAQ Marketplace Rule 4450(b)(1)(A) (the “Market Value Rule”). This notice was the subject of the Company’s filing on Form 8-K filed on July 17, 2008.

Thereafter, on August 12, 2008, the Company received an additional notification from the Listing Qualifications division of The NASDAQ Stock Market indicating that the Company’s Class A common stock is subject to potential delisting from The NASDAQ Global Market because for the prior 30 consecutive business days, the bid price of the Company’s Class A common stock closed below the minimum $1.00 per share requirement for continued inclusion under NASDAQ Marketplace Rule 4450 (the “Bid Price Rule”). This notice was the subject of the Company’s filing on Form 8-K filed on August 12, 2008.

In accordance with NASDAQ Marketplace Rule 4450(e)(4), the Company was provided a period of 30 calendar days, or until August 18, 2008, to regain compliance with the Market Value Rule, and, in accordance with NASDAQ Marketplace Rule 4450(e)(2), the Company was provided 180 calendar days, or until February 9, 2009, to regain compliance with the Bid Price Rule.

On August 19, 2008, the Company received notification from The NASDAQ Stock Market indicating that the Company failed to regain compliance with the Market Value Rule for continued inclusion on The NASDAQ Global Market. Under the NASDAQ rules, Wave requested an appeal hearing before the Listings Qualifications Panel (the “Panel”).  The hearing was held on October 23, 2008.  Wave has requested that the Panel permit Wave to transfer its listing to The NASDAQ Capital Market and grant

30

Wave additional time to meet the $35 million market capitalization requirement for that market.  The Company’s shares will continue to be listed on The NASDAQ Global Market pending the outcome of the appeal.  Wave expects a decision from the Panel within 30 days of the hearing date.

The Company has not regained compliance with the Market Value Rule and, therefore, the Panel may not grant continued listing on The NASDAQ Global Market.  The Company also does not currently meet the $35 million dollar market capitalization listing requirement for The NASDAQ Capital Market and, therefore, the Panel may not grant the Company’s request to transfer its listing to that market.

If our common stock ceases to be listed for trading on The NASDAQ Global Market and our listing is not transferred to The NASDAQ Capital Market, we expect that our common stock would be traded on the “Pink Sheets” or the NASD’s Over-the-Counter Bulletin Board (OTC-BB).  The level of trading activity of our common stock may decline if it is no longer listed on The NASDAQ Global Market or NASDAQ Capital Market and this may harm our stock price, increase the volatility of our stock price and make it more difficult to sell shares of our common stock.

Item 6.  Exhibits.

(a)Exhibits

Exhibit No.		Description of Exhibit
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

31

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.

	WAVE SYSTEMS CORP.
	(Registrant)
Dated: November 10, 2008	By:	/s/ Steven K. Sprague
	Name: Steven K. Sprague
	Title: President and Chief Executive Officer
Dated: November 10, 2008	By:	/s/ Gerard T. Feeney
	Name: Gerard T. Feeney
	Title: Chief Financial Officer

32