Wave Systems (WAVX) 10-Q 2009 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2009

OR

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

For the transition period from                      to                    

Commission File Number 0-24752

Wave Systems Corp.

(Exact name of registrant as specified in its charter)

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

480 Pleasant Street

Lee, Massachusetts 01238

(Address of principal executive offices)

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes o 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 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 o
Non-accelerated filer o	Smaller reporting company x
(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 August 3, 2009: 72,732,818 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 June 30, 2009

Index

		PAGE NO.
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	Consolidated Balance Sheets at June 30, 2009 and December 31, 2008	3
	Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2009 and 2008	4
	Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)	5
	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2009 and 2008	6
	Notes to Unaudited Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	25
Item 4.	Controls and Procedures	25
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	26
Item 1A.	Risk Factors	26
Item 4.	Submission of Matters to a Vote of Security Holders	33
Item 6.	Exhibits	33

2

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Balance Sheets

(Unaudited)

	June 30,			December 31,
	2009			2008
Assets
Current assets:
Cash and cash equivalents	$	506,460		$	951,563
Accounts receivable, net of allowance for doubtful accounts of $16,364 at June 30, 2009 and December 31, 2008	1,638,697			1,701,829
Prepaid expenses	278,688			227,967
Total current assets	2,423,845			2,881,359
Property and equipment, net	303,217			408,440
Other assets	129,639			139,975
Total Assets	2,856,701			3,429,774
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable and accrued expenses	7,016,773			7,655,834
Current portion of capital lease payable	60,445			63,537
Deferred revenue	1,249,543			1,484,044
Total current liabilities	8,326,761			9,203,415
Long-term portion of capital lease payable	215,024			245,362
Total liabilities	8,541,785			9,448,777
Stockholders’ Equity (Deficit):
8% Series I Convertible Preferred stock, $.01 par value. 220 shares issued and outstanding (liquidation preference of $968,000) in 2009 and 2008	2			2
Series J Convertible Preferred stock, $.01 par value. 91 shares issued and -0- outstanding (liquidation preference of $-0-) in 2009 and 91 shares issued and outstanding (liquidation preference of $364,000) in 2008	—			1
8% Series K Convertible Preferred stock, $.01 par value. 456 shares issued and -0- outstanding (liquidation preference of $-0-) in 2009 and 456 shares issued and outstanding (liquidation preference of $1,276,800) in 2008	—			5
Common stock, $.01 par value. Authorized 150,000,000 shares as Class A; 67,379,602 shares issued and outstanding in 2009 and 58,877,968 in 2008	673,796			588,780
Common stock, $.01 par value. Authorized 13,000,000 shares as Class B; 38,232 shares issued and outstanding in 2009 and 2008	382			382
Capital in excess of par value	340,197,584			338,081,691
Accumulated deficit	(346,556,848		)	(344,689,864		)
Total Stockholders’ Equity (Deficit)	(5,685,084		)	(6,019,003		)
Total Liabilities and Stockholders’ Equity (Deficit)	$	2,856,701		$	3,429,774

See accompanying notes to unaudited consolidated financial statements.

3

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Statements of Operations

(Unaudited)

	Three months ended						Six months ended
	June 30, 2009			June 30, 2008			June 30, 2009			June 30, 2008
Net revenues:
Licensing	$	4,424,492		$	1,946,100		$	8,155,388		$	3,621,605
Services	373,148			39,193			676,433			62,767
Total net revenues	4,797,640			1,985,293			8,831,821			3,684,372
Operating expenses:
Licensing — cost of sales	184,729			209,707			350,401			368,868
Services — cost of sales	202,441			29,869			384,829			48,183
Selling, general, and administrative	2,948,138			4,243,656			6,326,659			8,540,746
Research and development	1,800,962			3,145,326			3,626,086			6,398,805
Total operating expenses	5,136,270			7,628,558			10,687,975			15,356,602
Operating loss	(338,630		)	(5,643,265		)	(1,856,154		)	(11,672,230		)
Other income (expense):
Interest income	375			3,370			484			22,287
Interest expense	(5,497		)	—			(11,314		)	—
Total other income (expense)	(5,122		)	3,370			(10,830		)	22,287
Net loss	$	(343,752	)	$	(5,639,895	)	$	(1,866,984	)	$	(11,649,943	)
Loss per common share — basic and diluted	$	(0.01	)	$	(0.10	)	$	(0.03	)	$	(0.22	)
Weighted average number of common shares outstanding during the period	66,375,990			53,949,513			64,134,741			52,424,014

See accompanying notes to unaudited consolidated financial statements.

4

WAVE SYSTEMS CORP. AND SUBSIDIARIES

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

(Unaudited)

8 % Series I Convertible Preferred Stock

Series J Convertible Preferred Stock

8 % Series K Convertible Preferred Stock

Class A Common Stock

Class B Common Stock

Capital in Excess of Par

Accumulated

Accumulated Other Comprehensive

Shares

Amount

Shares

Amount

Shares

Amount

Shares

Amount

Shares

Amount

Value

Deficit

Income

Total

Balance as of December 31, 2008	220	$	2	91		$	1		456		$	5		58,877,968	$	588,780	38,232	$	382	$	338,081,691		$	(344,689,864	)	$	—	$	(6,019,003	)
Net loss	—	—		—		—			—		—			—	—		—	—		—			(1,866,984		)	—		(1,866,984		)
Conversion of 8% Series K Preferred Stock for Class A Common Stock	—	—		—		—			(456	)	(5		)	4,560,000	45,600		—	—		(45,595		)	—			—		—
Issuance of Class A Common Stock at $0.55 per share, less issuance cost of $55,904	—	—		—		—			—		—			785,000	7,850		—	—		367,995			—			—		375,845
Cash dividends paid on 8% Series I Preferred Stock	—	—		—		—			—		—			—	—		—	—		(38,720		)	—			—		(38,720		)
Issuance of Class A Common Stock at $0.55 per share, less issuance cost of $92,077	—	—		—		—			—		—			1,881,136	18,811		—	—		923,736			—			—		942,547
Conversion of Series J Preferred Stock for Class A Common Stock	—	—		(91	)	(1		)	—		—			910,000	9,100		—	—		(9,099		)	—			—		—
Issuance of Class A Common Stock pursuant to the Wave Employee Stock Purchase Plan at $0.28	—	—		—		—			—		—			365,498	3,655		—	—		98,867			—			—		102,522
Dividends accrued on 8% Series I Preferred Stock	—	—		—		—			—		—			—	—		—	—		(22,717		)	—			—		(22,717		)
Stock based compensation	—	—		—		—			—		—			—	—		—	—		841,426			—			—		841,426
Balance as of  June 30, 2009	220	$	2	—		$	—		—		$	—		67,379,602	$	673,796	38,232	$	382	$	340,197,584		$	(346,556,848	)	$	—	$	(5,685,084	)

See accompanying notes to unaudited consolidated financial statements.

5

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

	Six months ended
	June 30,			June 30,
	2009			2008
Cash flows from operating activities:
Net loss	$	(1,866,984	)	$	(11,649,943	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	125,563			174,038
Compensation associated with issuance of stock options	841,426			1,205,239
Changes in assets and liabilities:
Decrease in accounts receivable	63,132			225,061
(Increase) decrease in prepaid expenses	(50,721		)	14,986
Decrease in other assets	10,336			313
(Decrease) increase in accounts payable and accrued expenses	(661,778		)	1,282,148
(Decrease) increase in deferred revenue	(234,501		)	299,614
Net cash used in operating activities	(1,773,527		)	(8,448,544		)
Cash flows from investing activities:
Acquisition of property and equipment	(20,340		)	(109,382		)
Net cash used in investing activities	(20,340		)	(109,382		)
Cash flows from financing activities:
Payments on capital lease obligation	(33,430		)	—
Net proceeds from issuance of common stock	1,420,914			4,989,954
Payment of dividends on preferred stock	(38,720		)	—
Net cash provided by financing activities	1,348,764			4,989,954
Net decrease in cash and cash equivalents	(445,103		)	(3,567,972		)
Cash and cash equivalents at beginning of period	951,563			3,714,030
Cash and cash equivalents at end of period	$	506,460		$	146,058
Supplemental cash flow information:
Non-cash financing activities:
Conversion of 8% Series K Preferred stock into Class A Common stock	$	45,600		$	—
Conversion of Series J Preferred stock into Class A Common stock	$	9,100		$	—
Cash paid during the period for:
Interest	$	11,314		$	—

See accompanying notes to unaudited consolidated financial statements.

6

WAVE SYSTEMS CORP. AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

June 30, 2009 and 2008

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the financial position of Wave Systems Corp. as of June 30, 2009 and December 31, 2008, its results of operations for the three-month and six-month periods ended June 30, 2009 and 2008, and cash flows for the six-month periods ended June 30, 2009 and 2008.  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 United States 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, 2008, included in its Form 10-K filed on March 16, 2009.  The results of operations for the three-month and six-month periods ended June 30, 2009 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 majority-owned subsidiary.  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 June 30, 2009, has an accumulated deficit of $346,556,848.  Wave is expecting to incur an operating loss for the calendar year 2009.  As of June 30, 2009, Wave had negative working capital of $5,902,916.

Wave has begun market introduction of its security and broadband media distribution software products and has signed initial distribution contracts for these applications.  However, due to the early stage nature of this market, it is unlikely that Wave will generate sufficient revenue to cover all of its cash flow needs to fund its operating requirements for the twelve-months ending June 30, 2010.

Because Wave does not have sufficient cash to fund operations for the twelve-months ending June 30, 2010; and given the uncertainties described above with respect to Wave’s revenue outlook for 2009, 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 June 30, 2010.  These activities include the sale of 3,448,042 shares of common stock, on July 16, 2009, at $0.92 per share for gross proceeds of $3,172,199.  We realized approximately $2,743,000 in net proceeds after deducting the placement agent fees of $253,776 and additional legal and other fees associated with the issuance of these securities totaling approximately $175,000.  In connection with the financing, we also agreed to issue warrants to the subscribers to purchase up to 1,724,024 shares of Wave Class A common stock for $1.155 per share.  These warrants expire in January 2015.  Following the July 16, 2009 financing, Wave sold an additional 1,791,738 shares of common stock on July 21, 2009, also at $0.92 per share, for gross proceeds of $1,648,400.  We realized approximately $1,487,000 in net proceeds after deducting the placement agent fees of $131,872 and additional legal and other fees associated with the issuance of these securities totaling approximately $30,000.  In connection with the financing, we also agreed to issue warrants to the subscribers to purchase up to 895,868 shares of Wave Class A common stock for $1.155 per share.  These warrants expire in January 2015.  Both of these financings were completed under a shelf registration filed with the SEC on April 18, 2008 and declared effective on June 23, 2008.

7

Wave may 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 June 30, 2010.

Considering our current cash balance (including the net proceeds from our July 16, 2009 and July 21, 2009 financings described above), Wave projects that it has enough liquid assets to continue operating through February 2010.  Wave estimates that it will need a minimum of approximately $2,000,000 of additional cash from a combination of revenue growth, expense reductions and additional financings, to fund operating expenses and capital expenditures for the twelve-months ending June 30, 2010.

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 June 30, 2010 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 and stock warrants.  Diluted net loss per share is equal to basic net loss per share and is therefore not presented separately in the financial statements.  The weighted average number of potential common shares that would have been included in diluted loss per share, had their effect not been anti-dilutive for each of the three-month and six-month periods ended June 30, 2009, were approximately 2,840,000 shares and 3,422,000 shares, respectively, versus 28,000 shares and 30,000 shares for the three-month and six-month periods ended June 30, 2008, respectively.  Employee stock options and other stock warrants to purchase a weighted average of approximately 16,968,000 and 16,284,000 shares were outstanding for the three-month and six-month periods ended  June 30, 2009, respectively versus 9,163,000 and 8,699,000 shares of the three-month and six-month periods ended June 30, 2008, respectively, but would not have been included in the computation of diluted loss per share because their exercise price was greater than the average share price of Wave’s common shares and, therefore, their effect would have been anti-dilutive.

3.      Wavexpress

Wave offered broadband content distribution products and services through Wavexpress and its TVTonic consumer media service, which was originally 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, dated October 15, 1999.

On December 1, 2008, Wavexpress announced that it had suspended its TVTonic consumer media service and was exploring opportunities to sell or license its technology to third parties that may provide “download and play” services.

Wave has funded Wavexpress through a series of convertible notes, some with attached warrants.  The notes bear interest at the rate of 2% to 3% above the prime rate of JP Morgan Chase Bank.  Generally, the notes are convertible into shares of common stock of Wavexpress at varying prices per share.  Through June 30, 2009, Wave has funded Wavexpress with approximately $46,414,000 in cash, plus approximately $27,820,000 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.

8

As of June 30, 2009, Wave owned 97.2% of Wavexpress, while Sarnoff owned 1.7% (on a fully diluted basis).  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 $29,000 and $816,000 for the three-month periods ended June 30, 2009 and June 30, 2008, respectively, and approximately $609,000 and $1,630,000 for the six-month periods ended June 30, 2009 and June 30, 2008, respectively.

4.     Recent Accounting Pronouncements

In May 2009, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 165, Subsequent Events (“SFAS No. 165”), which provides guidance to establish general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued. SFAS No. 165 also requires entities to disclose the date through which subsequent events were evaluated as well as the rationale for why that date was selected. SFAS No. 165 is effective for interim and annual periods ending after June 15, 2009. The adoption of SFAS No. 165 did not have an impact on our financial position or results of operations. We evaluated all events or transactions that occurred after June 30, 2009 up through August 10, 2009, the date our financials were issued. During this period, we did not have any material recognizable subsequent events (see Note 10).

In June 2008, the FASB ratified EITF Issue No. 08-4, Transition Guidance for Conforming Changes to Issue No. 98-5 (“EITF No. 08-4”). Per EITF No. 08-4, conforming changes made to EITF Issue No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, that result from EITF Issue No. 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments, and SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, was effective for us beginning after January 1, 2009.  The implementation of this standard did not have a material impact on Wave’s consolidated financial statements.

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 was effective for the Company as of November 15, 2008.  The implementation of this standard did not have a material impact on Wave’s consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 147”).  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.  The impact of the adoption of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities did not have a material impact on Wave’s consolidated financial statements. See Note 9 for additional fair value disclosures.

5.     Share-based Compensation

Wave recognized $419,385 and $588,450 of share-based compensation during the three-months ended June 30, 2009 and 2008, respectively, and $841,426 and $1,205,239 for the six-month periods ended June 30, 2009 and 2008, respectively.  During the three-month period ended June 30, 2009, Wave granted 198,500 stock options at a weighted-average estimated fair value of $0.40.  During the three-month period ended June 30, 2008, Wave granted 55,000 stock options at a weighted-average estimated fair value of $0.89.

9

The following table summarizes the effect of share based compensation in Wave’s statement of operations, for the three-month and six-month periods ended June 30, 2009 and 2008:

	Three months ended June 30,				Six months ended June 30,
	2009		2008		2009		2008
Cost of Sales	$	15,728	$	9,376	$	35,883	$	18,894
Selling, General & Administrative	251,476		345,623		514,014		714,564
Research & Development	152,181		233,451		291,529		471,781
Total	$	419,385	$	588,450	$	841,426	$	1,205,239

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 $278.0 million, which expire beginning in 2009 through 2028.  Wave also has capital loss carryforwards for tax return purposes of approximately $7.5 million, which expire in 2009 and 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 occurred prior to or following Wave’s initial public offering in September 1994 and, potentially, in periods following, 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 net interest income (expense).  This item is not reported by segment since it is excluded from the measurement of segment performance reviewed by Wave’s management.

The following sets forth reportable segment data:

	Three months ended June 30,						Six months ended June 30,
	2009			2008			2009			2008
Operating Revenues:
EMBASSY® digital security products and services	$	4,797,640		$	1,985,293		$	8,831,821		$	3,684,372
Wavexpress broadband media distribution	—			—			—			—
Total Operating Revenues	4,797,640			1,985,293			8,831,821			3,684,372
Net Loss:
EMBASSY® digital security products and services	(315,214		)	(4,827,176		)	(1,258,263		)	(10,042,186		)
Wavexpress broadband media distribution	(23,416		)	(816,089		)	(597,891		)	(1,630,044		)
Total Segments Net Loss	(338,630		)	(5,643,265		)	(1,856,154		)	(11,672,230		)
Net interest income (expense)	(5,122		)	3,370			(10,830		)	22,287
Net Loss	(343,752		)	(5,639,895		)	(1,866,984		)	(11,649,943		)
Depreciation and Amortization Expense:
EMBASSY® digital security products and services	63,072			76,708			125,563			151,004
Wavexpress broadband media distribution	—			11,514			—			23,034
Total Depreciation and Amortization Expense	63,072			88,222			125,563			174,038
Capital Expenditures:
EMBASSY® digital security products and services	4,771			16,869			20,340			102,022
Wavexpress broadband media distribution	—			—			—			7,360
Total Capital Expenditures	$	4,771		$	16,869		$	20,340		$	109,382

10

	June 30,		December 31,
	2009		2008
Assets:
EMBASSY® digital security products and services	$	2,841,129	$	3,367,690
Wavexpress broadband media distribution	15,572		62,084
Total Assets	$	2,856,701	$	3,429,774

The following table details Wave’s sales by geographic area for the three and six-month periods ended June 30, 2009 and 2008.  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 June 30, 2009:
EMBASSY® digital security products and services	$	4,629,340		$	3,000		$	165,300		$	4,797,640
Wavexpress broadband media distribution	—			—			—			—
Total	4,629,340			3,000			165,300			4,797,640
% of Total Revenue	97		%	0		%	3		%	100		%
Three months ended June 30, 2008:
EMBASSY® digital security products and services	$	1,945,826		$	3,624		$	35,843		$	1,985,293
Wavexpress broadband media distribution	—			—			—			—
Total	1,945,826			3,624			35,843			1,985,293
% of Total Revenue	98		%	0		%	2		%	100		%
Six months ended June 30, 2009:
EMBASSY® digital security products and services	$	8,631,040		$	3,200		$	197,581		$	8,831,821
Wavexpress broadband media distribution	—			—			—			—
Total	8,631,040			3,200			197,581			8,831,821
% of Total Revenue	98		%	0		%	2		%	100		%
Six months ended June 30, 2008:
EMBASSY® digital security products and services	$	3,581,799		$	30,887		$	71,686		$	3,684,372
Wavexpress broadband media distribution	—			—			—			—
Total	3,581,799			30,887			71,686			3,684,372
% of Total Revenue	97		%	1		%	2		%	100		%

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

11

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

		Three months ended June 30,						Six months ended June 30,
		2009			2008			2009			2008
Customer	Segment	Revenue						Revenue
Dell, Inc.	EMBASSY®	$	3,614,691		$	1,623,802		$	6,942,236		$	2,983,195
% of Total Revenue		75		%	82		%	79		%	81		%

8.      Issuance of Common Stock

On February 5, 2009, all 456 shares of the 8% Series K Convertible Preferred Stock (“Series K Preferred Stock”) sold by Wave in an offering on December 24, 2008 automatically converted into 4,560,000 shares of Class A common stock, as the average of the closing bid prices for the fifteen-day trading period ending February 5, 2009 was $0.706, exceeding the bid price target of $0.70 per share.  Each share of Series K Preferred Stock issued in connection with the offering was 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 $0.70.

On March 13, 2009, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 785,000 shares of Class A common stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $431,750.  These shares were priced at $0.55 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 392,500 shares of Class A common stock at an exercise price of $0.55 per share.  These warrants expire in March 2013.  Additionally, Wave agreed to issue a warrant to SRA to purchase up to 47,100 shares of Class A common stock at an exercise price of $0.55 per share.  This warrant expires in March 2013.  Wave realized net proceeds of approximately $376,000 after deducting the placement agent fees of $25,905 and additional legal and other fees associated with the issuance of these securities which totaled approximately $30,000.  The shares sold on March 13, 2009 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 April 8, 2009, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 1,881,136 shares of Class A common stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $1,034,625.  These shares were priced at $0.55 per share.  SRA entered into a placement agency agreement with Wave in which they agreed to act as placement agent in connection with the offering.  Wave agreed to pay SRA a fee equal to 6.0% of the gross proceeds of this offering.  Wave also agreed to issue warrants to the subscribers to purchase up to 940,568 shares of Class A common stock at an exercise price of $0.55 per share.  These warrants expire in April 2012.  Additionally, Wave agreed to issue a warrant to SRA to purchase up to 112,868 shares of Class A common stock at an exercise price of $0.55 per share.  This warrant expires in April 2012.  Wave realized net proceeds of approximately $942,500 after deducting the placement agent fees of $62,077 and additional legal and other fees associated with the issuance of these securities which totaled approximately $30,000.  The shares sold on April 8, 2009 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 1, 2009, Wave issued 365,498 shares of Class A common stock to Wave employees for $0.28 per share, pursuant to the Wave 2004 Employee Stock Purchase Plan.  Wave received proceeds of $102,522, from the sale of these shares.

On June 9, 2009, all 91 shares of the Series J Convertible Preferred Stock (“Series J Preferred Stock”) sold by Wave in an offering on October 31, 2008 automatically converted into 910,000 shares of Class A common stock, as the average of the closing bid prices for the fifteen-day trading period ending June 9, 2009 was $1.001, exceeding the bid price target of $1.00 per share.  Each share of Series J Preferred Stock issued in connection with the offering was 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 $1.00.

9.     Fair Value Measurement

As of June 30, 2009, 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 $506,500 at June 30, 2009) 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.

10.   Subsequent Events

On July 16, 2009, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 3,448,042 shares of Class A Common Stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $3,172,199.  These shares were priced at $0.92 per share.  Roth Capital Partners (“Roth”) entered into a placement agency agreement with Wave in which Roth agreed to act as placement agent in connection with the offering.  Wave agreed to pay Roth a fee equal to 8.0% of the gross proceeds of this offering.  Wave also agreed to issue warrants to the subscribers to purchase up to 1,724,024 shares of Class A common stock at an exercise price of $1.155 per share.  These warrants expire in January 2015.  Wave realized net proceeds of approximately $2,743,000 after deducting the placement agent fees of $253,776 and additional legal and other fees associated with the issuance of these securities which totaled approximately $175,000.  Additionally, on July 21, 2009 Wave agreed to sell and issue 1,791,738 shares of Class A Common Stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $1,648,400.  These shares were priced at $0.92 per share.  Roth entered into a placement agency agreement with Wave in which Roth agreed to act as placement agent in connection with

12

the offering.  Wave agreed to pay Roth a fee equal to 8.0% of the gross proceeds of this offering.  Wave also agreed to issue warrants to the subscribers to purchase up to 895,868 shares of Class A common stock at an exercise price of $1.155 per share.  These warrants expire in January 2015.  Wave realized additional net proceeds of approximately $1,487,000 after deducting the placement agent fees of $131,872 and additional legal and other fees associated with the issuance of these securities which totaled approximately $30,000.  The shares sold on July 16 and July 21, 2009 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

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

Wave 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 organization comprised of computer and device manufacturers, software vendors and other computing products manufacturers. 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.

In 2008, we accepted an invitation from the TCG to assume a permanent seat on its Board of Directors (the “TCG Board”), joining permanent members AMD, Fujitsu, HP, IBM, Infineon, Intel, Lenovo, Microsoft and Sun.  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.

One of the current TCG specifications recommends a hardware-based trusted computing platform, which is a platform that uses a semiconductor device, known as a Trusted Platform Module (“TPM”) that contains protected storage and performs protected activities, including platform authentication, protected cryptographic processes and capabilities allowing for the attestation of the state of the platform which

13

provides the first level of trust for the computing platform (a “Trusted Platform”).  The TPM is a hardware chip that is separate from the platform’s main CPU(s) that enables secure protection of files and other digital secrets, and performs critical security functions such as generating, storing and protecting “cryptographic keys,” which are secret codes used to decipher  encrypted or coded data.  While TPMs provide the anchor for hardware security, known as the “root of trust”, trust is achieved by integrating the TPM within a carefully architected trust infrastructure and supporting the TPM with essential operational and lifecycle services; such as key management and credential authentication.

Management has focused on entering into licensing contracts pursuant to which the original equipment manufacturer, or OEM, licenses our applications and distributes them as part of their offering, paying Wave a royalty for each unit shipped. Wave currently has signed such bundling agreements with eight separate OEM partners.  Revenue recognized on these contracts for the three-month periods ended June 30, 2009 and 2008 was approximately $4,079,000 and $1,905,000, respectively. For the six-month periods ending June 30, 2009 and 2008, revenue recognized on these contracts amounted to approximately $7,535,000 and $3,517,000, 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 2008, Wave’s eSign division announced enhancements to its eTMS product offering.  Closing documents can now be signed and notarized in a secure environment and the note then registered through the Mortgage ElectronicRegistry 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.

Wave offered broadband content distribution products and services through Wavexpress and its TVTonic consumer media service, which was originally 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, dated October 15, 1999.  On December 1, 2008, Wavexpress announced that it had suspended its TVTonic consumer media service and was exploring opportunities to sell or license its technology to third parties that may provide “download and play” 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.

14

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.

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 $2.5 million for the twelve-month period ending June 30, 2010.

Middleware and Tools

TCG-Enabled Toolkit

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

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

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

Current planned development costs for this product group are expected to be approximately $3.1 million for the twelve-month period ending June 30, 2010.

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.

15

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.

EMBASSY Remote Administration Server (“ERAS”)

ERAS is a server product that provides centralized management and auditing of TPMs and Seagate Trusted Drives.  ERAS is designed to give IT administrators the ability to deploy and remotely manage Trusted Drives and TPM systems.  It provides for initialization, pre-boot authentication management, recovery, and repurposing of TPMs and Seagate Trusted Drives.  ERAS is designed to provide auditing capabilities that aid in compliance management by allowing for validation of TPM and Seagate 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 Seagate Trusted Drive technology as it provides IT administrators with tools to utilize the security of these devices while reducing deployment and management costs.  During November 2008, Wave announced the availability of enhanced versions of EMBASSY Trust Suite, including TDM, which incorporate support for the new Seagate Momentus FDE 7200-RPM and 5400.3-RPM self-encrypting drives shipping on Dell’s new E-Series notebook PCs.  In December 2008, Wave and Fujitsu Computer Products of America, Inc. showcased their self-encrypting drive solution at the Network World IT Roadmap Conference & Expo in San Francisco.  Fujitsu’s 2.5-inch High Definition Drive is the first technology that will meet the Opal Security Subsystem Class (SSC) specification — an industry standard recently issued by the TCG.  The SSC gives vendors an industry standard for developing self-encrypting drives that secure data.  During 2008, Wave worked with Fujitsu, Toshiba, Samsung and Hitachi to develop Opal-compliant FDE solutions, in addition to its currently shipping Seagate Trusted Drives.

Current planned development costs for this product are expected to be approximately $1.6 million for the twelve-month period ending June 30, 2010.

Digital Signature and Electronic Document Management

Our eSign Transaction Management Suite, also known as eTMS (“eTMS”), originally 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.  During October 2008, Wave announced enhancements to its electronic signature and vaulting software.  With the latest enhancements to eTMS, closing documents can be signed and notarized in a secure environment and the note then registered through the Mortgage Electronic Registry System, the industry endorsed system for electronically tracking mortgage ownership and servicing rights.  Additionally, eTMS has added an optional SmartClose module which offers lenders protection against borrowers claiming not to have understood their debt obligation.  Lenders can now require electronic initialing on key line items — a critical feature for refuting borrower calls to nullify the loan.  The module also offers electronic notarization through the integration of the World Wide Notary’s DigiSign application with SmartSafe.  The SmartClose module provides critical functionality to enable true e-Mortgages.

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 in minutes at a lower cost compared to traditional paper-based documentation methods. 

16

SmartSignature Version 3.0 and SmartSAFE Version 4.0 have been completed and Wave commercially released these products in the first quarter of 2007.  SmartIdentity, an optional service to verify a signer’s identity through strong authentication methods, including issuing encrypted digital certificates based on public key infrastructure technology, was completed and released in January of 2003.  Wave will continue to allocate resources toward marketing and sales to promote these products.

Wave’s eTMS, in addition to 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”) and Uniform Electronic Transaction Act (“UETA”).  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: Ellie Mae, Realtime Solutions Group, Heritage Union, DocuTech, Remark, American Community Life Insurance Company, Trust Company of America, SigniaDocs, Xerox Mortgage Services 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 $350,000 for the twelve-month period ending June 30, 2010.

Broadband Media Distribution Services

Wave offered broadband content distribution products and services through Wavexpress and its TVTonic consumer media service, 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, dated October 15, 1999.  As of March 31, 2009, Wave owned 97.2% of Wavexpress, while Sarnoff owned 1.7% (on a fully diluted basis).

On December 1, 2008, Wavexpress announced that it had suspended its TVTonic consumer media service and was exploring opportunities to sell or license its technology to third parties that may provide “download and play” services.

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.

17

R&D

Wave has realized minimal operating revenues since its inception.  At June 30, 2009, Wave had an accumulated deficit of approximately $346.6 million.  Wave has made a substantial investment in research and development including $1.8 million for the quarter ended June 30, 2009, and expects to continue to make substantial investments in its products and technology.  For the years ended December 31, 2008, 2007 and 2006, Wave spent approximately $11.7 million, $10.6 million and $8.5 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 United States 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, accounts receivable reserves, valuation of long-lived and intangible assets, accounting for joint ventures, software development 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 is included in the notes to Wave’s audited financial statements for the year ended December 31, 2008, included in its Form 10-K filed with the Securities and Exchange Commission on March 16, 2009.

Results of Operations

Three-Months Ended June 30, 2009 and 2008

Wave had revenues of $4,797,640 and $1,985,293 for the three-months ended June 30, 2009 and 2008, respectively.  The increase in revenue was due primarily to a $2,478,392 increase in licensing revenues during the three months ended June 30, 2009 as compared to the same period in 2008.  This increase was due to higher per-unit royalty rates earned during the quarter ended June 30, 2009, primarily as a result of Wave’s OEM relationship with Dell as described below.  The increase in per-unit royalty rates was due to an amendment of Wave’s software license agreement with Dell.  The amendment was entered into in December 2008, and was retroactive to November 1, 2008.  Pursuant to the amendment, the per-unit royalties that Wave receives for each Dell PC model shipping with Wave’s EMBASSY Trust Suite software were increased by at least 100% per unit.  The amendment states that this increase in per unit royalty could be cancelled prospectively by Dell or Wave upon 30 days notice.  Services revenue, consisting primarily of non-recurring government time and materials contracts, increased by $333,955 during the quarter.  This increase was due primarily to revenue earned from a $748,640 contract awarded by the United States Department of Defense.  Under the contract, Wave provides consulting services in connection with a study to evaluate the implementation of trusted computing solutions for the United States government.

18

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

	2009		2008		Increase		% Change
Licensing	$	4,424,492	$	1,946,100	$	2,478,392	127	%
Services	373,148		39,193		333,955		852	%
Total Net Revenues	$	4,797,640	$	1,985,293	$	2,812,347	142	%

Cost of sales - licensing, consisting primarily of customer support and share-based compensation expense in accordance with SFAS 123(R), was $184,729, for the three-months ended June 30, 2009, compared to $209,707 for the same period in 2008.  The change in cost of sales - licensing was due to a decrease in customer support staff for the quarter ended June 30, 2009 versus the prior period.  Cost of sales - services, consisting primarily of non-recurring government time and materials costs, was $202,441, for the three-months ended June 30, 2009, compared to $29,869 for the same period in 2008.  The change in cost of sales - services was due to an increase in non-recurring government time and materials costs in connection with the contract with the United States Department of Defense during the quarter ended June 30, 2009 versus the prior period.  In order to enhance the comparability of its results of operations with other security software providers in the industry, Wave has reclassified for all periods presented the cost of sales to a component of operating expenses.  As a result, a gross profit analysis is not presented.

Selling, general and administrative (“SG&A”) expenses for the three-months ended June 30, 2009 were $2,948,138, as compared to $4,243,656 for the comparable period of 2008, a decrease of approximately 31%.  The decrease was due primarily to a decrease in salaries and related benefits totaling approximately $186,000, associated with planned headcount reductions, a decrease of approximately $147,000 in travel expenses, a decrease of approximately $102,000 in public relations expenditures, a decrease of approximately $195,000 in conference and trade show expenditures and a decrease of approximately $394,000 in professional fees as compared to the three months ended June 30, 2008.  Included in the SG&A expenses listed above are Wavexpress’ selling, general and administrative expenses, which were $8,987 and $401,513 for the quarters ended June 30, 2009 and 2008, respectively.  This decrease was due to the suspension of its TVTonic consumer media service as of December 1, 2008.

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 June 30, 2009 were $1,800,962 as compared to $3,145,326 for the comparable period of 2008, a decrease of 43%.  This decrease was primarily attributable to decreased salaries, fringe and benefit expenditures of approximately $736,000 at Wave and $364,000 at Wavexpress, associated with headcount reductions, as compared to the three-months ended June 30, 2008.  In addition, professional fees, consisting primarily of consulting fees, decreased approximately $82,000 in the quarter ended June 30, 2009 versus the comparable period of 2008.  Wavexpress’ research and development expenditures included in the above were $14,430 and $414,576 for

19

the quarters ended June 30, 2009 and 2008, respectively.   This decrease was due to the suspension of its TVTonic consumer media service as of December 1, 2008.

Interest income for the three-months ended June 30, 2009 was $375 as compared to $3,370 for the comparable period of 2008.  The decrease in interest income is primarily attributable to lower average balances of Wave’s money market accounts for the quarter ended June 30, 2009 compared with the same period in 2008.

Interest expense for the three-months ended June 30, 2009 was $5,497 as compared to $-0- for the comparable period of 2008.  The increase is primarily attributable to interest incurred on the capital lease obligation for equipment acquired for the expansion of the Wavexpress broadband infrastructure in September 2008.

Due to the reasons set forth above, our net loss to common stockholders for the three-months ended June 30, 2009 was $343,752 as compared to $5,639,895 for the comparable period of 2008.

Six Months Ended June 30, 2009 and 2008

Wave had revenues of $8,831,821 and $3,684,372 for the six-month period ended June 30, 2009, and 2008, respectively.  The increase in revenue was due primarily to a $4,533,783 increase in licensing revenues during the six-month period as compared to the same period in 2008.  This increase was due to higher per-unit royalty rates earned during the six months ended June 30, 2009, primarily as a result of Wave’s OEM relationship with Dell.  As noted above, the increase in per-unit royalty rates was due to an amendment of Wave’s software license agreement with Dell.  The amendment was entered into in December 2008, and was retroactive to November 1, 2008.  Pursuant to the amendment, the per-unit royalties that Wave receives for each Dell PC model shipping with Wave’s EMBASSY Trust Suite software were increased by at least 100% per unit.  The amendment states that this increase in per unit royalty could be cancelled prospectively by Dell or Wave upon 30 days notice.  Services revenue, consisting primarily of non-recurring government time and materials contracts, increased by $613,666 during the six-month period.  This increase was due primarily to revenue earned from a $748,640 contract awarded by the United States Department of Defense.  Under the contract, Wave provides consulting services in connection with a study to evaluate the implementation of trusted computing solutions for the United States government.

The table below sets forth the components that made up the revenue for the six-month period ended June 30:

	2009		2008		Increase		% Change
Licensing	$	8,155,388	$	3,621,605	$	4,533,783	125	%
Services	676,433		62,767		613,666		978	%
Total Net Revenues	$	8,831,821	$	3,684,372	$	5,147,449	140	%

Cost of sales - licensing, consisting primarily of customer support and share-based compensation expense in accordance with SFAS 123(R), was $350,401, for the six-months ended June 30, 2009, compared to $368,868 for the same period in 2008.  The change in cost of sales - licensing was due to a decrease in customer support staff during the six-months ended June 30, 2009 versus the prior period.  Cost of sales - services, consisting primarily of non-recurring government time and materials costs, was $384,829, for the six-months ended June 30, 2009, compared to $48,183 for the same period in 2008.  The change in cost of sales - services was due to an increase in non-recurring government time and materials costs in connection with the contract with the United States Department of Defense during the six-months ended June 30, 2009 versus the prior period.  In order to enhance the comparability of its results of operations with other security

20

software providers in the industry, Wave has reclassified for all periods presented the cost of sales to a component of operating expenses.  As a result, a gross profit analysis is not presented.

SG&A expenses for the six months ended June 30, 2009, were $6,326,660, as compared to $8,540,746 for the comparable period of 2008, a decrease of approximately 26%.  The decrease was due primarily to a decrease in salaries and related benefits totaling approximately $445,000 associated with headcount reductions, a decrease of approximately $387,000 in travel expenses, a decrease of approximately $256,000 in public relations expenditures, a decrease of approximately $108,000 in conference and trade show expenditures and a decrease of approximately $741,000 in professional fees as compared to the six months ended June 30, 2008.  Included in the SG&A expenses listed above are Wavexpress’ selling, general and administrative expenses, which were $431,457 and $795,454 for the six months ended June 30, 2009 and 2008, respectively.  This decrease was due to the suspension of its TVTonic consumer media service as of December 1, 2008.

Research and development expenses for the six months ended June 30, 2009, were $3,626,086, as compared to $6,398,805 for the comparable period of 2008, a decrease of 43%.  This decrease was primarily attributable to decreased salaries, fringe and benefit expenditures of approximately $1,539,000 at Wave and $717,000 at Wavexpress, associated with headcount reductions, as compared to the six-months ended June 30, 2008.  In addition, product development costs, consisting of language translation charges, decreased approximately $200,000 and professional fees, consisting primarily of consulting fees, decreased approximately $179,000 in the six-months ended June 30, 2009 versus the comparable period of 2008.  Wavexpress’ research and development expenditures included in the above were $166,434 and $834,590 for the six-months ended June 30, 2009 and 2008, respectively.   This decrease of approximately 60% was due primarily to the decrease in salaries, fringe and benefit expenditures noted above as a result of the suspension of Wavexpress’ TVTonic consumer media service as of December 1, 2008.

Interest income for the six months ended June 30, 2009, was $484 as compared to $22,287 for the comparable period of 2008.  The decrease in interest income is primarily attributable to lower average balances of Wave’s money market accounts for the six months ended June 30, 2009 compared with the same period in 2008.

Interest expense for the six-months ended June 30, 2009 was $11,314 as compared to $-0- for the comparable period of 2008.  The increase is primarily attributable to interest incurred on the capital lease obligation for equipment acquired for the expansion of the Wavexpress broadband infrastructure in September 2008.

Due to the reasons set forth above, our net loss to common stockholders for the six months ended June 30, 2009, was $1,866,985 as compared to $11,649,943 for the comparable period of 2008.

Liquidity and Capital Resources

Wave has experienced net losses and negative cash flow from its operations since its inception, and, as of June 30, 2009, had an accumulated deficit of $346,556,848.   Total stockholders’ deficit as of June 30, 2009 was $5,685,084.  Wave has financed its operations through June 30, 2009 principally through the issuance of Class A and B Common Stock and several series of preferred stock.

Sources and uses of cash

As of June 30, 2009, Wave had $506,460 in cash and cash equivalents.  As of December 31, 2008, Wave had $951,563 in cash and cash equivalents.  The decrease in cash and cash equivalents of $445,103, resulted from (i) $1,773,527 used in operating activities and (ii) $20,340 used in investing activities for the acquisition of capital assets offset by (iii) $1,348,764 generated through financing activities, from the sale of 3,031,634 shares of Class A common stock, including 365,498 shares sold pursuant to Wave’s Employee Stock

21

Purchase Plan, partially offset by the payment of dividends on Wave’s 8% Series I Preferred stock and payments on a capital lease obligation.  At June 30, 2009, Wave had negative working capital of $5,902,916.

Liquidity requirements and future sources of capital

Wave estimates that its total expenditures to fund operations for the twelve-months ending June 30, 2010 will be approximately $20,400,000, 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  $506,460 as of June 30, 2009;

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

·additional financings.

Given Wave’s capital requirements for the twelve-month period ending June 30, 2010 as indicated above and Wave’s cash on hand as of June 30, 2009, Wave will be required to raise additional capital to fund its operations.  On July 16, 2009, Wave entered into subscription agreements, pursuant to which Wave agreed to sell and issue 3,448,042 shares of Class A common stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $3,172,199.  These shares were priced at $0.92 per share.  Roth Capital Partners (“Roth”) entered into a placement agency agreement with Wave in which Roth agreed to act as placement agent in connection with the offering.  Wave agreed to pay Roth a fee equal to 8.0% of the gross proceeds of this offering.  Wave also agreed to issue warrants to the subscribers to purchase up to 1,724,024 shares of Class A common stock at an exercise price of $1.155 per share.  These warrants expire in January 2015.  Wave realized net proceeds of approximately $2,743,000 after deducting the placement agent fees of $253,776 and additional legal and other fees associated with the issuance of these securities which totaled approximately $175,000.  Following the July 16, 2009 transaction, on July 21, 2009, Wave entered into subscription agreements pursuant to which Wave agreed to sell and issue an additional 1,791,738 shares of Class A common stock, par value $.01 per share, to certain purchasers for an aggregate purchase price of $1,648,400.  These shares were priced at $0.92 per share.  Roth entered into a placement agency agreement with Wave in which Roth agreed to act as placement agent in connection with the offering.  Wave agreed to pay Roth a fee equal to 8.0% of the gross proceeds of this offering.  Wave also agreed to issue warrants to the subscribers to purchase up to 895,868 shares of Class A common stock at an exercise price of $1.155 per share.  These warrants expire in January 2015.  Wave realized net proceeds of approximately $1,487,000 after deducting the placement agent fees of $131,872 and additional legal and other fees associated with the issuance of these securities which totaled approximately $30,000.  The shares sold on July 16, 2009 and July 21, 2009 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.

We may obtain additional funding as needed, from further sales of newly issued shares of Class A common stock or preferred stock, including the sale of Class A common stock or preferred stock under the remaining availability of our $25,000,000 shelf registration statement that we filed on April 18, 2008 and was declared effective by the Commission on June 23, 2008, or from debt financing or a combination of these sources.  Approximately $9,447,000 in gross proceeds is available under the April 18, 2008 shelf registration statement, 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.

22

Revenue outlook

Wave receives revenue from licensing its EMBASSY Trust Suite software through distribution arrangements with OEM partners as described below.  In addition, Wave received revenues from software development and other services.  Total cash received from all revenue sources for the six-months ended June 30, 2009 was approximately $8,590,000 versus approximately $4,187,000 for the comparable period of 2008.

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

Wave’s OEM distribution agreements began to generate royalty revenue in the second quarter of 2006.  The aggregate amount of royalty revenue from these arrangements was a significant contributor to Wave’s revenue growth to date.  Revenue from these agreements 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.  In December 2008, Wave completed an amendment to its software license agreement with its largest OEM customer, Dell Products LP.  Under the new arrangement, the per-unit royalties that Wave receives for each Dell PC model shipping with Wave’s EMBASSY Trust Suite software were increased by at least 100% per unit, retroactive to November 1, 2008.  This increase in per unit royalty may be cancelled prospectively by Dell or Wave upon 30 days notice.

In mid-October 2008, Wave completed an OEM distribution agreement with Acer, Wave’s eighth OEM partner and the world’s third-largest PC vendor, to bundle Wave EMBASSY® software with Acer’s new Veriton™ 670 business PCs.  Wave is being paid a per unit royalty fee for each Acer shipment which includes Wave’s software.  Shipments in Europe and Asia began during the fourth quarter of 2008.  U.S. shipments are expected to begin in mid-2009.

The OEM distribution agreements referred to above have given rise to separate software upgrade contracts with enterprise customers/end users.  We refer to these contracts as license upgrade agreements.  These contracts include a software license and a maintenance agreement.  These contracts are separately negotiated with end users and are not associated with the OEM distribution agreements.

Sales from these upgrade contracts began in the latter part of the third quarter of fiscal year 2007.  These sales consist of licensed use of the Company’s EMBASSY Trust Suite of products - primarily the Company’s EMBASSY Security Center paired with the Company’s ERAS server product.  Billings for license upgrades amounted to approximately $601,000 for the six-months ended June 30, 2009 versus approximately $181,000 for the comparable period of 2008.  Given that Wave is in the early stages of its software upgrade and maintenance business and consistent with the Company’s revenue recognition policies, Wave has not yet established vendor-specific objective evidence of the fair value of each undelivered element for its software and services.  Accordingly, Wave’s license upgrade sales are being recorded as deferred revenue and then recognized generally over a 365-day period.  Wave recognized approximately $561,000 of license upgrade revenue during the six-months ended June 30, 2009 versus approximately $58,000 for the comparable period of 2008.  Deferred revenue decreased by approximately $235,000 during the six-months ended June 30, 2009 due primarily to the recognition of previously deferred revenue associated with work performed for Toshiba and Fujitsu on developing self-encrypting drives that secure data.

Known trends and uncertainties affecting future cash flows

Because Wave does not have sufficient cash to fund operations for the twelve-months ending June 30, 2010 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 June 30, 2010.  These activities include the filing of

23

a $25,000,000 shelf registration statement on Form S-3 with the SEC on April 18, 2008 which was declared effective on June 23, 2008 (for which there is approximately $9,447,000 remaining for future financings).

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 June 30, 2010.   The availability and amount of any such financings are unknown at this time and we cannot assure you that we will be successful in securing future financing. 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 June 30, 2010, we estimate that we will need to generate at least $2,000,000 from a combination of revenue growth and additional financing activities, in order to continue as a going concern for the twelve-months ending June 30, 2010.

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 generate revenues to cover its operating costs, it will need to continue 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 June 30, 2010.  We may be unable to raise additional capital, in which case we would be unable to continue our operations, develop or enhance our products and continue as a going concern.

The challenges presented by the current economic downturn may impact the volume of shipments by our OEM partners of products equipped with our software and general demand for our products is uncertain.

Commitments

Wave has a capitalized lease obligation for computer equipment due July 2013. As of June 30, 2009, $275,469 was outstanding under this obligation.  The interest rate is 7.7% per annum.  This lease obligation is collateralized by the related assets with a net book value of $-0- as of June 30, 2009 as a result of an impairment charge due to the suspension of Wavexpress’ TVTonic consumer media services on December 1, 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:

	Within one year		Years two and three		Years four and five		Thereafter		Total
Capital lease commitment	$	60,445	$	133,639	$	81,385	$	—	$	275,469
Operating leases commitments	805,158		1,075,544		358,321		—		2,239,023
Total commitments	$	865,603	$	1,209,183	$	439,706	$	—	$	2,514,492

Net operating and capital loss carryforwards

As of December 31, 2008, Wave had available net operating and capital loss carryforwards for federal income tax purposes of approximately $285.5 million, which expire beginning in 2009 through 2028.  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

24

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, 2008, dated March 16, 2009, 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 December 31, 2008 consolidated financial statements.)

Off-Balance Sheet Arrangements

As of June 30, 2009, we did not have any off-balance sheet arrangements, as defined in Item 301(a)(4)(ii) of Securities and Exchange Commission (“SEC”) Regulation S-K.

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.

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) to allow timely decisions regarding required disclosure.

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 CEO and CFO, of the effectiveness of Wave’s disclosure and control procedures pursuant to Rule 13a-15 of the Exchange Act.  Based on that evaluation, the CEO and CFO have concluded that Wave’s disclosure controls and procedures were effective as of June 30, 2009 to ensure that information required to be disclosed by Wave in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.

There has been no change in our internal controls over financial reporting that occurred during the fiscal quarter ended June 30, 2009 that has materially affected, or is reasonably likely to materially affect, Wave’s internal controls over financial reporting.

25

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.

Our business, financial condition and results of operation may be adversely affected by the unprecedented economic and market conditions.

The current global economic downturn could significantly and adversely affect our business, financial condition and results of operation in various ways.  The decline in economic conditions has or may negatively impact the demand for our products and services and our ability to conduct our business, thereby reducing our revenues and earnings.  In addition, the economic downturn, has or may negatively impact, among other things:

·our continued growth and development of our business;

·our liquidity;

·our ability to raise capital and obtain financing; and

·the price of our common stock.

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 ended June 30, 2009 was below operating expenses, as our products have not yet attained widespread commercial acceptance. This is due in part to the early stage nature of the digital security industry in which we operate. As of June 30, 2009, we had an accumulated deficit of approximately $346.6 million and negative working capital of approximately $5.9 million. 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.

To achieve profitability we must, among other things:

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

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

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

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

26

·Continue to develop relationships with personal computer manufacturers, computer chip manufacturers and computer systems integrators to facilitate and to maximize acceptance of our products and services; and

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

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

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

Since we began our operations, we have incurred net losses and experienced significant negative cash flow from operations. This is due to the early stage nature of market development for our products and services and the digital security industry as a whole. Wave expects to continue to incur substantial additional expenses associated with continued research and development and business development activities that will be necessary to commercialize our technology. This will likely result in significant losses for the foreseeable future. Considering our current cash balance, which includes the net proceeds received from the financing transactions completed on July 16th and 21st 2009, and Wave’s projected operating cash requirements, we anticipate that our existing capital resources will be adequate to satisfy our cash flow requirements through February 2010. In order to fund our business beyond February 2010, 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, assuming current revenue levels for non-Dell sales, assuming current shipment volumes for Dell at a per unit royalty rate that increased by at least 100% per unit on November 1, 2008 and taking into account the financings completed in July 2009, we estimate that our current available capital is sufficient to fund Wave through February 2010. In addition to our efforts to begin to generate revenue sufficient to fund our operations, or complete one or more commercial or strategic transactions, Wave is evaluating additional financing options to generate additional capital in order to continue as a going concern, to capitalize on business opportunities and market conditions and to insure the continued development of our technology, products and services. We estimate, based upon our current forecasts, we will need to generate a minimum of $2.0 million from a combination of revenue growth, commercial or strategic transactions and/or additional financings, to continue as a going concern for the twelve months ended June 30, 2010. We expect we will be required to generate a significant portion of this cash through additional financings in the form of a sale of newly issued securities.  While we recently completed financings in the form of sales of Class A Common Stock on July 16th and 21st 2009, we do not know if additional financing will be available or that, if available, it will be available on favorable terms. As we issue additional shares of our stock, our stockholders’ ownership will be diluted.  Also, the shares issued may have rights, preferences or privileges senior to those of our common stock.  In addition, if we pursue debt financing we may be required to pay interest costs.  The failure to generate sufficient cash flow to fund our forecasted expenditures would require us to reduce our cash burn rate which would in turn impede our ability to achieve our business objectives.  Furthermore, if we are not successful in generating sufficient cash flow or obtaining additional funding, we will be unable to continue our operations, develop or enhance our products, take advantage of future opportunities, respond to competitive pressures and continue as a going concern.

A single customer accounts for a significant portion of our revenues and, therefore, the loss of that customer may have a material adverse effect on our results of operations.

We expect that a small number of customers will continue to account for a large portion of our revenues for the foreseeable future. We have one customer that accounted for approximately 80% of our revenue in

27

2008. If our relationships with our large customers were disrupted, we could lose a significant portion of our anticipated revenue which may have a material adverse effect on our results of operations.

Factors that could influence our relationships with our customers, among other things, include:

·our ability to sell our products at prices that are competitive with our competitors;

·our ability to maintain features and quality standards for our products sufficient to meet the expectations of our customers; and

·our ability to produce and deliver a sufficient quantity of our products in a timely manner to meet our customers’ requirements.

If our OEM customers fail to purchase our components or to sell sufficient quantities of their products incorporating our components, or if our OEM customers’ sales timing and volume fluctuates, it may have a material adverse effect on our results of operations.

Sales to a relatively small number of OEM customers, as opposed to direct retail sales to end customers, comprise a large portion of our revenues. For example, we have one customer that accounted for approximately 80% of our revenue in 2008. Our ability to make sales to OEM customers depends on our ability to compete on price, delivery and quality. The timing and volume of these sales depend upon the sales levels and shipping schedules for the products into which our OEM customers incorporate our products. Thus, even if we develop a successful component, our sales will not increase unless the product into which our component is incorporated is successful. If our OEM customers decide not to incorporate our products as components of their products, or fail to sell a sufficient quantity of products incorporating our components, or if the OEM customers’ sales timing and volume fluctuate, it may lead to a reduction in sales and have a material adverse effect on our results of operations.

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 product 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

28

consumers of computer systems. Therefore, uncertainty remains as to whether we will be accepted as a supplier to the enterprise and consumer markets, which will likely be necessary for us to be a successful commercial enterprise.

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

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

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

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

We 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.  If the security of our products or services is breached, our results of operations may be materially adversely affected by the liability resulting from the breach.

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

29

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.

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.

30

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

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

Most of our software products are controlled under various United States export control laws and regulations and may require export licenses for certain exports of the products and components outside of the United States and Canada. With respect to our EMBASSY Trust Suite 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.

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.  A violation of foreign regulations could limit our access to such markets and have a negative effect on our results of operations.

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

31

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, 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.

If our common stock ceases to be listed for trading on the NASDAQ Capital Market, it may harm our stock price and make it more difficult to sell shares.

Our common stock is listed on the NASDAQ Capital Market.  In order to maintain our NASDAQ listing, NASDAQ Marketplace Rule 4450(b)(4) requires that the bid price for our common stock not fall below $1.00 per share for a period of 30 consecutive trading days.  Because of the volatility in our common stock price, there can be no assurance that we will be able to maintain compliance with this requirement. If our minimum bid price remains below $1.00 for 30 consecutive trading days, under the current NASDAQ Capital Market rules, we will have a period of 180 days to attain compliance by meeting the minimum bid price requirement for 10 consecutive days during the compliance period.  In the event that we do not regain compliance during such 180 day period, we would be entitled to an additional 180 day compliance period if we meet the other initial listing requirements of the NASDAQ Capital Market at the end of such initial 180 day period.  If our common stock ceases to be listed for trading on the NASDAQ Capital Market, we expect that our common stock would be traded on the NASD’s Over-the-Counter Bulletin Board (OTC-BB).  The level of trading activity

32

of our common stock may decline if it is no longer listed on the NASDAQ Capital Market.  As such, if our common stock ceases to be listed for trading on the NASDAQ Capital Market for any reason, it may harm our stock price, increase the volatility of our stock price and make it more difficult to sell your shares of our common stock.

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

On June 22, 2009, Wave held its Annual Meeting of shareholders.  At the Annual Meeting, the shareholders voted on the following matters:

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

DIRECTOR	FOR	AGAINST	WITHHELD	ABSETENTIONS AND BROKER NON-VOTES
John E. Bagalay, Jr.	53,309,166	0	3,008,148	0
Nolan Bushnell	53,353,358	0	2,963,956	0
George Gilder	54,124,082	0	2,193,232	0
John E. McConnaughy, Jr.	53,856,612	0	2,460,702	0
Steven Sprague	54,282,233	0	2,035,082	0

Ratifying the action of the Board of Directors in amending the 1994 Employee Stock Option Plan to increase the number of shares of Class A Common Stock authorized for issuance thereunder from 10,500,000 to 14,000,000. The amendment was approved with the following results: For: 10,307,209; Against: 1,097,183; Withheld: 0; Abstentions and Broker Non-Votes: 115,860.

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

33

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:  August 10, 2009		By:	/s/ Steven K. Sprague
		Name:	Steven K. Sprague
		Title:	President and Chief Executive Officer
Dated:  August 10, 2009		By:	/s/ Gerard T. Feeney
		Name:	Gerard T. Feeney
		Title:	Chief Financial Officer

34