Edgar Filing: NETWORK 1 SECURITY SOLUTIONS INC

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U. S. Securities and Exchange Commission

WASHINGTON, D.C. 20549

FORM 10-KSB

[X] ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2002.

[X] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ___________.

Commission File Number: 1-14896

NETWORK-1 SECURITY SOLUTIONS, INC.
(Name of small business issuer in its Charter)

DELAWARE 11-3027591
(State or other jurisdiction (IRS Employer
of incorporation) Identification Number)

445 PARK AVENUE, SUITE 1028
NEW YORK, NEW YORK 10022
(Address of Principal Executive Offices)

Issuer's telephone number : (212) 829-5770

Securities registered under Section 12(b) of the Exchange Act:

Title of each class Name of each exchange on which registered
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Common Stock, $.01 par value None

Securities registered under Section 12(g) of the Exchange Act:

None

Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 [ ] No [X]

Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [ ]

The issuer's revenues for its most recent fiscal year: $592,000.

The aggregate market value of the voting stock of the registrant held by
non-affiliates computed by reference to the price at which the stock was sold on
August 29, 2003 was approximately $337,218.

The number of shares of Common Stock outstanding as of August 31, 2003 was
8,314,458.

Transitional Small Business Disclosure Format (Check One): Yes [ ] No [X]

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PART I

THIS ANNUAL REPORT ON FORM 10-KSB CONTAINS CERTAIN STATEMENTS WHICH ARE
FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE SAFE HARBOR PROVISIONS OF
SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE
SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. ACTUAL RESULTS, EVENTS AND
CIRCUMSTANCES (INCLUDING FUTURE PERFORMANCE, RESULTS AND TRENDS) COULD DIFFER
MATERIALLY FROM THOSE SET FORTH IN SUCH STATEMENTS DUE TO VARIOUS RISKS AND
UNCERTAINTIES, INCLUDING BUT NOT LIMITED TO, THOSE DISCUSSED IN THE SECTION
ENTITLED "RISK FACTORS THAT MAY AFFECT FUTURE RESULTS" IN ITEM 1 OF THIS REPORT
AS WELL AS THOSE RISKS DISCUSSED ELSEWHERE IN THIS REPORT.

ITEM 1. DESCRIPTION OF BUSINESS.

BACKGROUND

UNTIL DECEMBER 2002, NETWORK-1 SECURITY SOLUTIONS, INC. (THE "COMPANY")
DEVELOPED, MARKETED AND LICENSED SECURITY SOFTWARE PRODUCTS DESIGNED TO PREVENT
UNAUTHORIZED ACCESS TO INFORMATION RESIDING ON AN ENTERPRISE'S COMPUTERS. IN
DECEMBER 2002, THE COMPANY DISCONTINUED OFFERING ITS SECURITY SOFTWARE PRODUCT
LINE AS IT WAS UNABLE TO ACHIEVE SUFFICIENT PRODUCT REVENUE TO SUPPORT THE
EXPENSES OF SUCH OPERATIONS. MANAGEMENT IS FOCUSING ITS EFFORTS ON SEEKING A
MERGER CANDIDATE FOR THE COMPANY. IN MAY 2003, THE COMPANY COMPLETED THE SALE OF
ITS CYBERWALLPLUS TECHNOLOGY AND RELATED INTELLECTUAL PROPERTY TO AN
UNAFFILIATED THIRD PARTY FOR $415,000. PROVIDED BELOW IS A DESCRIPTION OF THE
BUSINESS OF THE COMPANY DURING THE YEAR ENDED DECEMBER 31, 2002.

Network-1 Security Solutions Inc. (the "Company") developed, marketed,
licensed and supported a suite of security software products designed to prevent
unauthorized access to critical information residing on networked servers,
desktops and laptops. The Company's CyberwallPLUS family of security software
products combined the benefits of firewall and intrusion detection technology
with central management features to provide an enterprise-class layer of
security protection directly on servers, desktops, wireless and mobile computers
(the "end-points"). The CyberwallPLUS family of security products competed in
the emerging "end-point" security market.

CyberwallPLUS delivered intrusion prevention through its firewall and
intrusion detection capabilities, a unique combination of technologies that
actively detected and blocked intrusions. CyberwallPLUS interrogated incoming
and outgoing traffic on the host servers, desktops and laptops by using stateful
inspection and behavior-based intrusion detection. The packet-filtering firewall
blocked unauthorized access to any of the 65,000 ports on a computer and
prevents the computer from launching attacks of its own directed at other
networked computers. The access controls and intrusion filters enabled security
policy, which was optimized to the specific computer, and dramatically increased
the machine's ability to deflect attacks or potential compromise.

The Company was incorporated under the laws of the State of Delaware in
July 1990. The Company's principal offices are located at 445 Park Avenue, Suite
2900, New York, New York 10022 and its telephone number is 212-829-5770.

THE NETWORK-1 SOLUTION

The CyberwallPLUS family of security software products represented the
latest generation of our host-based security solution that integrated a powerful
range of security techniques to actively detect and block intrusions thereby
providing effective "end-point" security.

CyberwallPLUS combined the benefits of firewall and intrusion
detection technology with central management features to provide an
enterprise-class layer of robust security protection directly on Microsoft
Windows-based servers, desktops, wireless and mobile computers. The Company's
distributed intrusion prevention software was a bi-directional layer of defense
that protected the network from the host machine, as well as protected the host
machine from the network, regardless of whether the source of attack is inside
or outside the organization. CyberwallPLUS also protected mobile and wireless
computers even when they connected to networks outside the organization's
control.

The Company's CyberwallPLUS family of host intrusion prevention products
operated on Windows 9x, Windows NT, Windows 2000, and Windows XP operating
system platforms. The CyberwallPLUS suite of products was first introduced in
January 1999, evolving from the Company's FireWall/Plus suite of security
software products and prior practice in security consulting and forensics.

The Company's applications address an organization's need for solutions
that improve information security in today's Internet-enabled technology
environments. Designed to reduce the total cost of ownership, the Company's
solutions deployed without difficulty, offered local or remote centralized
management features, integrated easily into existing management infrastructures,
and complemented existing security investments.

The Company's solution started out by inhibiting intruders from even
discovering computer assets with "stealth mode", a technique that gave the
appearance that no system is present at a given IP address. Fine-grained access
control, bi-directional protection and stateful packet inspection typically
found in high-end perimeter firewalls combined with powerful intrusion detection
and prevention capabilities to add a critical second layer of defense behind
existing perimeter firewalls.

CyberwallPLUS's centralized policy management enabled detailed security
policies to be formulated, distributed, and monitored, maximizing IT security
resources. The logging features were designed to meet the requirements for legal
forensic evidence as well as timely alerts. CyberwallPLUS coexisted or
interoperated easily with many other security and management components,
including virus checkers, enterprise monitoring systems, and enterprise VPNs.

PRODUCTS AND SERVICES

The Company maintained two classes of CyberwallPLUS products - host
intrusion prevention solutions and network and perimeter firewall solutions -
each with a corresponding central manager module.

HOST INTRUSION PREVENTION. The Company's host solutions controlled access
to desktops, laptops, and servers. The Company released three revisions of
CyberwallPLUS host products, culminating with the release of version 7.3 in July
2002. The product suite included:

CYBERWALLPLUS FOR DESKTOPS AND LAPTOPS. CyberwallPLUS-WS
ran on Windows 9x, Windows NT/2000, and Windows XP client systems
and provided a necessary complement to mail-only antivirus scanners.
The packet-filtering firewall blocked unauthorized access to any of
the 65,000 ports on the end point (computer), and prevented that
computer from launching any attacks of its own directed at other
network resources. The combination of firewall and intrusion
detection technology was comparable to robust perimeter security
technology, but optimized for an end point computer.
CyberwallPLUS-WS also ensured that a computer operates in stealth
mode, making it invisible to scanning programs typically used by
hackers to locate computers on the network. In addition, at the
option of the network administrator, CyberwallPLUS-WS could have
been operated in silent mode so that the computer user did not have
access to the product and thus can not make any changes to its
configuration.

CYBERWALLPLUS FOR SERVERS. The CYBERWALLPLUS-SV server
edition was intended for all Microsoft application, database, or
infrastructure servers to provide a layer of local self-defense
against unauthorized access. Remote access to public servers such as
Web servers, Microsoft Exchange Server mail servers, or even
Intranet and database servers creates vulnerability in an
organization's protection scheme. The access controls and intrusion
filters enabled security policy which was optimized to the specific
server, and dramatically increased its ability to deflect attacks or
compromise.

CYBERWALLPLUS CENTRAL MANAGER. CYBERWALLPLUS-CM, a
management application enabling control and monitoring of multiple
CyberwallPLUS installations, responded to an organization's need to
easily and centrally manage and maintain the Company's solution
distributed across the corporate network. Complementing existing
management environments, CyberwallPLUS offers local, remote, and
centralized management; policy deployment and management; logging
and reporting to existing management systems; and centralized
license deployment and license inventory capabilities.

NETWORK AND PERIMETER FIREWALLS. The Company also offered a set of network
and perimeter firewalls to complete a layered network defense strategy. The
product suite included:

CYBERWALLPLUS INTERNET PROTOCOL. Designed to protect a
computer network from Internet attacks and intrusions,
CYBERWALLPLUS-IP installed as either a transparent bridge or router
on the network perimeter. CYBERWALLPLUS-IP, an ICSA (International
Computer Security Association) certified product, thwarted malicious
attacks originating on either side of the network through its
advanced firewall and active intrusion detection/prevention
capabilities. The network security software ran on Windows NT/2000
systems configured with two Ethernet interfaces and features an
advanced packet filter engine that provided fine-grained network
access controls, sophisticated intrusion detection and prevention
algorithms, and detailed traffic audit logs.

CYBERWALLPLUS MULTI-PROTOCOL. Ideally suited for
internal network security, CYBERWALLPLUS-MP was a high-speed local
area network (LAN) segment firewall controlling access between
internal networks. It operated as a two-port Ethernet bridge and
supports hundreds of IP and non-IP protocols. It provided network
administrators with the network access controls and intrusion
detection tools needed to secure multi-protocol Ethernet LANs from
outside attacks.

Network-1's solutions contained the following features or attributes:

ADVANCED PACKET FILTERING SYSTEM. CyberwallPLUS provided both inbound and
outbound packet filtering; passing traffic based on network access rules. These
rules restricted packet flow, protecting the network and the systems connected
to the network from unnecessary and potentially malicious traffic.

STATEFUL PACKET INSPECTION AND DYNAMIC PORT ALLOCATION. CyberwallPLUS
examined packets to determine whether or not to pass the packet based on the
state of the connection. Should the state of the connection be other than
anticipated, CyberwallPLUS did not pass the packet to the destination because
the packet was not considered stateful. Stateful inspection was also necessary
for dynamic port allocation. With dynamic port allocation, certain protocols may
request the one-time opening of a subsidiary connection on additional ports that
are opened and closed when the application requires them, yet blocked when not
in use. Through Stealth mode operation, CyberwallPLUS did not respond to
requests on blocked ports, thus making it more difficult for attackers to
"fingerprint" or detect the computer for attack, rather than responding to an
unauthorized query with a "connection not allowed" message which would reveal
the existence of the computer on the network.

SILENT MODE. Silent mode allowed the CyberwallPLUS product to operate
without the local user interface present. In enterprise deployments, this gave
central administrators control over configuration, policy, and monitoring of
host systems without involving or disturbing the end user.

CENTRALIZED MANAGEMENT. Enterprise environments benefit from
CyberwallPLUS's scalable creation of groups of individual hosts and the
distribution of policies and licenses across a large number of machines.
Multiple industry standard logging formats were supported to enhance the
integration of CyberwallPLUS with existing enterprise management systems.

CUSTOMIZED SECURITY POLICIES. Security policies could be customized for
individual departments, and individual systems and personnel within the network.
In addition, CyberwallPLUS allowed the creation and tailoring of templates to
support custom applications, protocols, and non-standard port configurations.

EASE OF USE. CyberwallPLUS was designed to be easily installed, configured
and managed by a network or system manager with minimal security skills through
an intuitive user interface. To facilitate implementation, CyberwallPLUS came
pre-programmed with a wide variety of frequently used default security policies
(templates) which required the customer to simply select one of the rule sets
and save the selection.

The Company's solutions were licensed on a per-machine basis, with licenses
for individual systems, or license packs with volume price breaks for multiple
systems, as well as site licenses, where applicable. The Company added to the
completeness of its solution by offering professional training, multi-year
product maintenance agreements, and 5/10 technical support plans. Deployment
services were offered through the Company's worldwide network of channel
partners.

SALES, MARKETING AND DISTRIBUTION

In the U.S., the Company directly marketed its products through a field
sales organization supported by inside sales representatives. The Company also
indirectly markets its products through regional value-added resellers (VARs)
who offer complementary technologies, including specialized government
resellers, and national integrators who had a focus or practice in security.
Internationally, the Company's network of regional/country resellers or
distributors provided sales interface with prospective customers. In July 2002,
the Company materially reduced its sales and marketing capacity as part of
cost-cutting measures. See "Management's Discussion and Analysis" at page 15
hereof.

DIRECT SALES. The Company`s direct marketing efforts targeted medium and
large-scale Microsoft Windows-centric enterprises with a large percentage of
mobile or remote employees in financial services, healthcare, higher education,
and government agencies or suppliers. The Company's sales professionals
qualified, developed and pursued leads based on a variety of marketing awareness
and lead generation programs, including event marketing, online advertising, and
direct mail, as well as downloaded product trials from its corporate Web site.
The first objective of the field sales staff was to develop end user
opportunities through a combination of on-site and remote interactions with the
prospect. The second objective of the field sales staff was to recruit,
cultivate and support indirect channel partners.

During the first half of 2002, the Company continued to expand its
international operations to address the rapid global adoption of distributed
computing environments. Many foreign countries do not have laws recognizing
network intrusion or misuse as a crime or the resources to enforce such laws if
they do exist. As a consequence, the Company believed that organizations in such
countries would have a greater need for effective security solutions. In the
first quarter of 2002, the Company established its Asia Pacific operations which
were headquartered in Shanghai, China. These operations

provided product development, sales, marketing and customer support in the Asia
Pacific region. In September, 2002, the Company ceased its operations in China
as part of significant cost-cutting measures.

INDIRECT SALES. The Company had relationships with national, regional and
local resellers and systems integrators. In addition, the Company had
relationships with international system integrators, VARs, resellers and
distributors. The Company's agreements with resellers generally grant the right
to market the Company's products in specified territories on a non-exclusive
basis, were terminable on short notice and do not prohibit the reseller from
selling products that were competitive with the Company's products.

FALCONSTOR LICENSE AND DISTRIBUTION AGREEMENT

Simultaneously with the closing of the Company's October 2001 private
offering of $6,765,000 of securities (See "Management's Discussion and Analysis
or Plan of Operation" at page 15 hereof), the Company entered into a ten (10)
year License and Distribution with FalconStor, pursuant to which FalconStor had
the right to distribute the Company's product offerings in its indirect and OEM
channels. As part of the Agreement, FalconStor paid the Company a non-refundable
advance of $500,000 against future royalty payments. On May 30, 2003, as part of
the Company's sale of its CyberwallPlus technology and related intellectual
property to an unaffiliated third party, the Company assigned its rights under
the FalconStor Agreement to the unaffiliated third party. (See "Management's
Discussion and Analysis or Plan of Operations" at pages 15-16).

CUSTOMERS

The Company's customers represented a wide range of industries and
institutions, both commercial and government, which considered networked-data
resources to be among the most important assets within their organizations.
During the year ended December 31, 2002 revenue from one customer accounted for
21% of the Company's revenues.

During the years ended December 31, 2002 and 2001, revenue from
international customers (licenses and service to foreign end users and
international distributors) accounted for 29% and 21% of our revenues,
respectively.

COMPETITION

The market for host intrusion prevention solutions is characterized by
intense competition and rapidly changing business conditions, customer
requirements and technologies.

EXISTING COMPETITION. The Company viewed its competition in several classes
as follows:

HOST INTRUSION PREVENTION FOR SERVER SYSTEMS RUNNING
MICROSOFT WINDOWS NT/2000. The Company's principal competitors
included operating system (OS) intercept vendors Entercept Security
Technologies and Okena, Inc.; and host intrusion detection system
(IDS) vendors Internet Security Systems, Inc., Enterasys Networks,
Inc., Symantec Corporation and NFR Security, Inc. Since there is a

wide array of server operating systems, as well as the types of
threats (operating system, application, network, file, etc.) that
can exist, no one solution is used independently.

HOST INTRUSION PREVENTION FOR ENTERPRISE
DESKTOPS/LAPTOPS RUNNING MICROSOFT WINDOWS 9X, WINDOWS NT/2000, OR
WINDOWS XP. The Company competed primarily with personal firewall
vendors, such as Internet Security Systems, Inc., Symantec
Corporation, Zone Labs, Inc., InfoExpress, Inc. and Sygate
Technologies, Inc.; VPN/Firewall vendors, such as Check Point
Software Technologies Ltd. and InfoExpress, Inc.; and Host IDS
vendors, such as Internet Security Systems, Inc.

NETWORK AND PERIMETER FIREWALL PRODUCTS. The Company's
primary source of competition was Check Point Software Technologies
Ltd., Symantec Corporation, NetScreen Corporation Inc., SonicWall,
Inc., and WatchGuard Technologies, Inc.

Most of the Company's competitors had longer operating histories, greater
name recognition, larger installed customer bases and possessed substantially
greater financial, technical, marketing and other competitive resources than the
Company. As a result, the Company's competitors were able to adapt more quickly
to new or emerging technologies or attacks, changes in customer requirements and
devote greater resources to the promotion and sale of their products than the
Company. While the Company believed that its CYBERWALLPLUS products did not
compete against manufacturers of other categories of security products (such as
encryption and authentication products), potential customers may have perceived
the products of such other companies as substitutes for the Company's products.

PRODUCT RESEARCH AND DEVELOPMENT

The security software market is dynamic, characterized by rapid changes in
technology and customer requirements, new product introductions and
enhancements, and emerging industry standards. The Company's research and
development department was responsible for the design, development and release
of the Company's products, and was focused on the continuous evolution of the
Company's products. Organized into development, quality assurance, and
documentation disciplines, the research and development team worked closely with
sales, marketing, and customer support in order to better understand market
needs and user requirements.

A full time development team located at the Company's Waltham,
Massachusetts headquarters had the primary responsibility for product
development and technology direction, which was augmented by staff located at
the Company's Shanghai, China operations center. Consultants were sometimes
retained to address specific areas of expertise on a limited basis. Beginning in
July 2002, the Company materially reduced its product development capacity as
part of cost-cutting measures. (See "Management's Discussion and Analysis" at
page 15 hereof).

During the years ended December 31, 2002 and 2001, the Company's total
product development costs, including the costs capitalized after technological
feasibility had been reached, were $1,599,000, and $2,209,000, respectively.

CUSTOMER SERVICE AND SUPPORT

One-year maintenance subscriptions were typically sold with software
licenses, and optional multi-year maintenance subscriptions were available
thereafter. The Company provided customer technical support as a component of
its annual maintenance subscriptions, which included phone, email, and Web-based
support. The Company's telephone and email support services were available
Monday through Friday between the hours of 8am and 6pm eastern standard time in
the United States. In November 2002 the Company discontinued offering its annual
support contracts and replaced it with a call based support service.

PROPRIETARY RIGHTS

The Company's success was substantially dependent on its proprietary
technologies. The Company did not hold any patents and relied on copyright and
trade secret laws, non-disclosure agreements with employees, consultants,
distributors and customers, including "shrink wrap" license agreements that were
not signed by the customer, and technical measures to protect the ideas,
concepts and documentation of the Company's proprietary technologies and
know-how. Such methods may not have afforded complete protection, and there can
be no assurance that third-parties will not independently develop substantially
equivalent or superior technologies or obtain access to the Company's
technologies, ideas, concepts and documentation. In addition, confidentiality
agreements between the Company and its employees, distributors or customers may
not have provided meaningful protection for the Company's proprietary
information in the event of any unauthorized use or disclosure.

On June 19, 2001, the Company was issued a U.S. trademark registration
(Reg. No. 2,462,262) for the mark CyberwallPlus for computer products. Although
the Company is not aware of any challenges to our rights to use this trademark,
there can be no assurance that the use of this mark would be upheld if
challenged.

Although the Company believed that its technologies and products had been
developed independently and did not infringe upon the proprietary rights of
others, there can be no assurance that the Company's technologies and products
in fact did not infringe. The Company is not aware of any patent infringement
charge or any violation of other proprietary rights claimed by any third party
relating to the Company or its products.

EMPLOYEES AND CONSULTANTS

As of August 31, 2003, the Company had two employees and one consultant.

RISK FACTORS THAT MAY AFFECT FUTURE RESULTS

The Company operates in a highly competitive environment that involves a
number of risks, some of which are beyond the Company's control. The following
discussion highlights the most material of the risks.

WE HAVE A HISTORY OF LOSSES, NO REVENUE FROM OPERATIONS AND WE MAY NOT BE
ABLE TO CONTINUE OUR OPERATIONS IN THE FUTURE.

We have incurred substantial operating losses since our inception, which
has resulted in an accumulated deficit of $40,422,000 as of December 31, 2002.
For the years ended December 31, 2002 and 2001, we incurred net losses of
$5,905,000 and $8,035,000, respectively. Since December 31, 2002, we have
continued to incur operating losses. We have financed our operations primarily
through the sales of equity and convertible debt securities as well as the sale
of our professional services business in February 2000. In December 2002, we
discontinued our offering of security software products and thus we currently
have no revenue from operations. While we have significantly reduced our
expenses in order to preserve cash for a merger transaction, we may not have
sufficient funds to continue our operations if we are unable to complete a
merger on a timely basis.

WE COULD BE REQUIRED TO STOP OPERATIONS IF WE ARE UNABLE TO COMPLETE A
MERGER.

We anticipate, based on our currently proposed plans and assumptions
(including the timetable of, costs and expenses associated with our continued
operations), that our current cash position will more likely than not be
sufficient to satisfy our operations and capital requirements through at least
September 2004. There can be no assurance, however, that such funds will not be
expended prior thereto. In the event our plans change, or our assumptions change
or prove to be inaccurate (due to unanticipated expenses, difficulties, delays
or otherwise), we could have insufficient funds to support our operations prior
to September 2004. We are currently actively seeking merger candidates, however
we do not have a definitive agreement with respect to any merger transaction.
Our inability to consummate a merger transaction on a timely basis would have a
material adverse effect on our operations, requiring us to possibly cease
operations. In addition, even if we consummate a merger, we still may not have
sufficient cash to support our new business operations or achieve material
revenues or profitability.

A MERGER TRANSACTION IS LIKELY TO INVOLVE SUBSTANTIAL DILUTION TO OUR
EXISTING STOCKHOLDERS.

In the event that we are able to consummate a merger transaction, any such
transaction is likely to involve substantial dilution to our existing
stockholders.

CONTROL BY BARRY RUBENSTEIN, WHEATLEY AFFILIATES AND FALCONSTOR SOFTWARE,
INC.

Barry Rubenstein, Wheatley Partners II, L.P. and other affiliated and
related entities and parties (the "Wheatley Parties") currently own 32% of our
outstanding voting stock (exclusive of any securities owned by FalconStor ). In
addition, FalconStor currently owns 15.9% of our outstanding voting stock. Barry
Rubenstein owns 15.2% of the outstanding

voting securities of FalconStor and other Wheatley Parties own an additional 10%
of the outstanding voting securities of FalconStor. Accordingly, Barry
Rubenstein and the Wheatley Parties together with FalconStor currently own 47.9%
of our outstanding voting securities (and beneficially own options and warrants
to purchase an additional 30.1% of our outstanding voting securities) and as a
result of their aggregate holdings would have the ability to control the outcome
of all matters submitted to a vote of our stockholders including the election of
directors, amendments to our Certificate of Incorporation and approval of
mergers and a sale of substantially all of our assets. Such consolidation of
voting power could also have the effect of delaying, deterring or preventing a
change in control of our company that might be beneficial to other stockholders.

WE REQUIRE THE CONSENT OF THE HOLDERS OF SERIES E PREFERRED STOCK FOR
CERTAIN CORPORATE ACTION.

In connection with our private offering of Series E Preferred Stock and
warrants completed in October 2001, we agreed that so long as the holders of the
outstanding shares of Series E Preferred Stock own at least 10% of our
outstanding voting stock, we will not take certain actions without the consent
of Wheatley Partners II, L.P., the designee of the holders of Series E Preferred
Stock and one of our principal stockholders. Such actions requiring the consent
of Wheatley Partners II, L.P. include, among others, (i) issuing securities
other than securities to be issued under our stock option plan, (ii) incurring
debt in excess of $250,000, (iii) entering into a merger, acquisition or sale of
substantially all of our assets and (iv) taking any action to amend our
Certificate of Incorporation or By-laws that could in any way adversely affect
the rights of the holders of the Series E Preferred Stock. Accordingly, the
holders of Series E Preferred Stock may not consent to certain actions that we
may consider to be in our best interest and the best interest of the holders of
Common Stock. For more information regarding the rights and preferences of the
Series E Preferred Stock, see our Current Report on Form 8-K filed with the SEC
on October 12, 2001.

WORLD INSTABILITY - TERRORISM.

The terrorist attacks on September 11, 2001 in the United States and the
declaration of war by the United States against terrorism has created
significant instability and uncertainty in the world which may continue to have
a material adverse effect on world financial markets, including financial
markets in the United States. In addition, such adverse political events may
have an adverse impact on economic conditions in the United States. Unfavorable
economic conditions in the United States may have an adverse effect on our
company including, but not limited to, our ability to consummate a merger
transaction.

DELISTING OF OUR SECURITIES FROM NASDAQ; RISKS RELATING TO LOW-PRICED
STOCKS.

On March 26, 2003 our common stock was delisted from The Nasdaq Stock
Market's SmallCap Market. As a result of the delisting, an investor could find
it more difficult to dispose of or to obtain accurate quotations as to the
market value of our common stock. Our common stock currently trades on the
over-the-counter market in the "pink sheets."

In addition, since our common stock has been delisted from trading on
Nasdaq and the trading price of our common stock is below $5.00 per share, our
common stock is considered a penny stock. SEC regulations generally define a
penny stock to be an equity security that is not listed on Nasdaq or a national
securities exchange and that has a market value of less than $5.00 per share,
subject to certain exceptions. The SEC regulations would require broker-dealers
to deliver to a purchaser of our common stock a disclosure schedule explaining
the penny stock market and the risks associated with it. Various sales practice
requirements are also imposed on broker-dealers who sell penny stocks to persons
other than established customers and accredited investors (generally
institutions). Broker-dealers must also provide the customer with current bid
and offer quotations for the penny stock, the compensation of the broker-dealer
and monthly account statements disclosing recent price information for the penny
stock held in the customer's account. As a result of the delisting of our Common
Stock from Nasdaq, investors may find it more difficult to obtain timely and
accurate quotes and execute trades in our common stock.

THE SIGNIFICANT NUMBER OF OPTIONS, WARRANTS AND CONVERTIBLE SECURITIES
OUTSTANDING MAY ADVERSELY AFFECT THE MARKET PRICE FOR OUR COMMON STOCK.

As of August 31, 2003, there are outstanding (i) options and warrants to
purchase an aggregate of 10,971,182 shares of our common stock at exercise
prices ranging from $.13 to $10.125, (ii) 2,714,562 shares of convertible
preferred stock which are convertible at any time into 5,358,494 shares of our
common stock and (iii) 2,499,130 additional shares of our common stock which may
be issued in the future under our stock option plan. To the extent that
outstanding options and warrants are exercised or preferred stock is converted,
your percentage ownership will be diluted and any sales in the public market of
the common stock underlying such options, warrants or convertible debt may
adversely affect prevailing market prices for our common stock.

WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK,
WHICH MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.

Our Board of Directors has the authority, without further action by the
stockholders, to issue 10,000,000 shares of preferred stock (of which only
231,054 shares of Series D Preferred Stock are outstanding and 2,483,508 shares
of Series E Preferred Stock are outstanding) on such terms and with such rights,
preferences and designations as our Board of Directors may determine. Such terms
may include restricting dividends on our common stock, dilution of the voting
power of our common stock or impairing the liquidation rights of the holders of
our common stock. Issuance of such preferred stock, depending on the rights,
preferences and designations thereof, may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions in Delaware law may restrict the ability of our stockholders to
authorize a merger, business combination or change of control.

ITEM 2. DESCRIPTION OF PROPERTY

The Company currently occupies approximately 300 square feet of office
space in New York City at a cost of $2,700 per month.

ITEM 3. LEGAL PROCEEDINGS

In January 2003, Richard J. Kosinski, former Chief Executive Officer,
President and a director, and Murray P. Fish, former Chief Financial Officer and
a director, commenced lawsuits against the Company in the Commonwealth of
Massachusetts, County of Essex, Superior Court, seeking severance and bonus
compensation and other benefits allegedly due them in the aggregate amount of
$400,000. Messrs. Kosinski and Fish also moved for an order of attachment,
temporary restraining order and preliminary injunction to prevent the Company
from transferring an aggregate of $400,000 of its funds pending the outcome of
the lawsuits. In February 2003, the Court denied plaintiffs' motions.

In June 2003, the Company entered into a settlement agreement with Mr.
Kosinski pursuant to which the Company paid Mr. Kosinski the sum of $127,000 in
full settlement of all claims asserted by him in the litigation. In addition, as
part of the settlement, Mr. Kosinski agreed to forfeit options to purchase
1,200,000 shares of the Company's Common Stock.

The Company intends to vigorously defend the lawsuit by Mr. Fish seeking
$200,000 in severance, bonus and other benefits allegedly due him and believes
it has meritorious defenses to the claims asserted.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

MARKET INFORMATION. The Company's Common Stock had traded from November 12,
1998 until March 26, 2003 on the NASDAQ SmallCap Market under the symbol "NSSI."
The Company's Common Stock currently trades on the over-the-counter market in
the "Pink Sheets". The following table sets forth, for the periods indicated,
the range of the high and low closing bid prices for the Common Stock as
reported on NASDAQ. Such prices reflect inter-dealer quotations, without retail
mark-up, mark-down or commission and may not necessarily represent actual
transactions.

YEAR ENDED DECEMBER 31, 2002 HIGH LOW
---- ---

Fourth Quarter $0.56 $0.13
Third Quarter $0.93 $0.50
Second Quarter $1.38 $0.62
First Quarter $2.23 $1.26

YEAR ENDED DECEMBER 31, 2001 HIGH LOW
---- ---

Fourth Quarter $2.26 $1.10
Third Quarter $1.40 $0.43
Second Quarter $2.16 $0.91
First Quarter $4.38 $1.34

On August 29, 2003, the last sale price for the Common Stock as reported on
the Pink Sheets was $.05 per share. The number of record holders of the
Company's Common Stock was 61 as of July 25, 2003. The Company believes that
there are in excess of 1,500 beneficial owners of its Common Stock.

DIVIDEND POLICY. The Company has never declared or paid any cash dividends
on its Common Stock and does not intend to declare or pay cash or other
dividends in the foreseeable future. The Board of Directors currently expects to
retain any future earnings, if any, for use in the operation and expansion of
its business. The declaration and payment of any future dividends will be at the
discretion of the Board of Directors and will depend upon a variety of factors,
including future earnings, if any, operations, capital requirements, the general
financial condition of the Company, the preferences of any series of Preferred
Stock, the general business conditions and future contractual restrictions on
payment of dividends, if any.

RECENT ISSUANCES OF UNREGISTERED SECURITIES. None.

EQUITY COMPENSATION PLAN INFORMATION

The following table summarizes share and exercise price information about
the Company's equity compensation plans as of December 31, 2002.

------------------------------------ ----------------------------- --------------------------- -------------------------------------
NUMBER OF SECURITIES TO BE NUMBER OF SECURITIES REMAINING
ISSUED UPON EXERCISE OF WEIGHTED-AVERAGE EXERCISE AVAILABLE FOR FUTURE ISSUANCE UNDER
OUTSTANDING OPTIONS, PRICE OF OUTSTANDING EQUITY COMPENSATION PLANS
WARRANTS AND RIGHTS OPTIONS, WARRANTS AND (EXCLUDING SECURITIES REFLECTED IN
(A) RIGHTS COLUMN (A))
------------------------------------ ----------------------------- --------------------------- -------------------------------------

Equity compensation plans approved
by security holders 3,154,498 $2.25 845,502
------------------------------------ ----------------------------- --------------------------- -------------------------------------
Equity compensation plans not
approved by security holders 0 -- 0
------------------------------------ ----------------------------- --------------------------- -------------------------------------
Total 3,154,498 $2.25 845,502
------------------------------------ ----------------------------- --------------------------- -------------------------------------

ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH
THE COMPANY'S FINANCIAL STATEMENTS, INCLUDING THE NOTES THERETO, INCLUDED
ELSEWHERE IN THIS FORM 10-KSB. EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED
HEREIN, THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS
AND UNCERTAINTIES, INCLUDING, BUT NOT LIMITED TO, THOSE DISCUSSED IN THE SECTION
ABOVE ENTITLED "RISK FACTORS WHICH MAY AFFECT FUTURE RESULTS" IN ITEM 1 OF THIS
REPORT AS WELL AS THOSE RISKS DISCUSSED IN THIS SECTION AND ELSEWHERE IN THIS
REPORT. BECAUSE SUCH STATEMENTS INVOLVE RISKS AND UNCERTAINTIES, ACTUAL RESULTS
MAY DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING
STATEMENTS.

OVERVIEW

Until December 2002, the Company continued to license and support a suite
of security software products designed to prevent unauthorized access to
critical information residing on networked servers, desktops and laptops. In
December 2002, the Company discontinued its products offerings, as operating
expenses continued to exceed product revenues, in order to preserve cash as the
Company seeks a merger transaction. Accordingly, the Company currently has no
revenue from operations and does not anticipate revenue until completion of a
merger transaction. In May 2003, the Company completed the sale of its
CyberwallPlus technology and related intellectual property to a

foreign corporation for an aggregate consideration of $415,000. As a part of
this sale, the Company also assigned its rights under the Distribution and
License Agreement with FalconStor (as described below).

To date the Company has incurred significant losses and, at December 31,
2002, had an accumulated deficit of $(40,422,000). During the third and fourth
quarters of 2002, the Company instituted certain measures to preserve cash
including substantial reductions in employees and the closing of its China
development office and Taiwan sales office. Beginning in July 2002, the Company
in a series of layoffs reduced its employees from 39 to its current level of 2
employees. At July 31, 2003, the Company had approximately $1,500,000 of cash
and cash equivalents. (See "Liquidity and Capital Resources" at page 18 hereof).
Although the Company is actively seeking a merger transaction, the Company may
not be able to consummate a merger transaction. In addition, in the event the
Company consummates a merger transaction, there is no assurance that it will be
successful. In addition, a merger transaction is likely to involve substantial
dilution in the interests of the Company's then existing stockholders. In
connection with a merger transaction, the Company may seek financing from third
parties and/or existing stockholders.

On October 2, 2001, the Company completed a $6,765,000 private offering of
Series E Preferred Stock and Warrants pursuant to a Securities Purchase
Agreement with investors (the "2001 Financing"). In accordance with the
Securities Purchase Agreement, an aggregate of 3,191,037 shares of Series E
Preferred Stock were sold to investors at a price of $2.12 per share together
with warrants to purchase 6,882,074 shares of Common Stock at an exercise price
of $1.27 per share. Such warrants expire on October 2, 2003. Each share of
Series E Preferred Stock is convertible into two (2) shares of Common Stock,
subject to adjustment. As the largest investor ($2,300,000) in the Financing,
FalconStor Software, Inc. ("FalconStor"), a storage networking infrastructure
software company, received an additional warrant to purchase 500,000 shares of
the Company's Common Stock (the "Additional Warrant"). Simultaneously with the
closing of the Financing, the Company and FalconStor entered into a ten year
Distribution and License Agreement (the "FalconStor Agreement") pursuant to
which FalconStor had the right to distribute the Company's product offerings in
its indirect and OEM channels. As part of the Distribution and License
Agreement, FalconStor paid the Company a non-refundable advance of $500,000
against future royalty payments of which, in accordance with accounting
principles generally accepted in the United States of America, $350,000 has been
accounted for as the purchase price of the Additional Warrant and this resulted
in total proceeds allocated to the 2001 Financing of $7,115,000. The balance of
deferred revenue related to this agreement at December 31, 2002 is $130,000. In
May 2003, as part of the Company's sale of its CyberwallPlus technology to a
foreign corporation, the Company assigned its rights under the FalconStor
Agreement.

The Company had committed significant product and development resources to
its CyberwallPLUS family of products. The Company capitalizes and amortizes
software development costs in accordance with Statement of Financial Accounting
Standards No. 86. These costs consist of salaries, consulting fees and
applicable overhead. The Company upon reviewing the valuation in accordance with
Financial Accounting Standards no. 144, "Accounting for the Impairment or
Disposal of Long-lived Assets", has written-off the remaining unamortized value
of the capitalized software of $401,000 during the year ended December 31, 2002.

CRITICAL ACCOUNTING POLICIES:

Revenue recognition:

License revenue is recognized upon delivery of software or delivery of a
required software key. License revenue from distributors or resellers is
recognized as the distributor or reseller delivers software or the required
software key to end users or original equipment manufacturers. Service revenues
consist of maintenance and training services. Annual renewable maintenance fees
are a separate component of each contract, and are recognized ratably over the
contract term. Training revenues are recognized as such services are performed.
Revenue from advance license fees are deferred until they are earned pursuant to
the agreements.

Software development costs:

Costs to maintain developed programs and development costs incurred to
establish the technological feasibility of computer software are expensed as
incurred. The Company capitalized costs incurred in producing computer software
after technological feasibility of the software has been established through the
date that the software is ready for general release to customers. Such costs are
amortized based on current and estimated future revenue of each product with an
annual minimum equal to the straight-line amortization over the remaining
estimated economic life of the product. The Company estimates the economic life
of its software to be three years. At each balance sheet date, the unamortized
capitalized software costs of each product are compared with the estimated net
realizable value of that product and any excess capitalized costs are written
off.

Impairment of long-lived assets:

In accordance with Statement of Financial Accounting Standards ("SFAS") No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets", the
Company records impairment losses on long-lived assets used in operations or
expected to be disposed of when indicators of impairment exist and the cash
flows expected to be derived from those assets are less than carrying amounts of
those assets. During the year ended December 31, 2002, the Company recorded an
impairment charge related to its network security software of approximately
$401,000, which has been included in amortization of software development costs.
Subsequently, in May 2003, the Company sold its network security software (see
Note L[4]). The Company also reduced the carrying value of its fixed assets to
their net realizable amount (see Note C).

Use of estimates:

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS:

In May 2002, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 145, "Recession of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections." SFAS No. 145 rescinds the
requirement that all gains and losses from extinguishment of debt be classified
as an extraordinary item. Additionally, SFAS No. 145 requires that certain lease
modifications that have economic effects similar to sale-lease back transactions
be accounted for in the same manner as sale-lease back transactions. This
statement is effective for the Company beginning in 2003. Management has not yet
determined what impact the adoption of SFAS No. 145 will have on the Company's
financial statements.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which addresses financial
accounting and reporting for costs associated with exit or disposal activities
and supersedes Emerging Issues Tax Force ("EITF") Issue 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity" (including "Certain Costs Incurred in a Restructuring"). SFAS No. 146
requires that a liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred. Under EITF Issue 94-3, a
liability for an exit cost as defined in EITF Issue 94-3 was recognized at the
date of an entity's commitment to an exit plan. SFAS No. 146 also establishes
that the liability should initially be measured and recorded at fair value. SFAS
No. 146 is effective for exit and disposal activities initiated after December
31, 2002. Management is currently evaluating the provisions of SFAS No. 146 but
expects that it will not have a material impact on the Company's results of
operations and financial position upon adoption.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure." This statement amends SFAS No. 123,
"Accounting for Stock-Based Compensation," to provide alternative methods of
transition for an entity that changes to the fair value method of accounting for
stock-based employee compensation. In addition, SFAS No. 148 amends the
disclosure provisions of SFAS No. 123 to require expanded and more prominent
disclosures in annual financial statements about the method of accounting for
stock-based compensation and the pro forma effect on reported results of
applying the fair value method for entities that use the intrinsic value method.
The pro forma disclosures are also required to be displayed prominently in
interim financial statements. The Company does not intend to change to the fair
value method of accounting and has included the disclosure requirements of SFAS
No. 148 in the accompanying financial statements.

SFAS No. 150, "Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity", which was issued in May 2003,
will require redeemable preferred stock to be classified, in certain
circumstances, as a liability, upon adoption by a public company at the
beginning of the first interim period beginning after June 15, 2003. SFAS No.
150 provides that mandatorily redeemable preferred stock should be classified as
a liability if it embodies an unconditional obligation requiring the issuer to
redeem the shares by transferring its assets at a specified or determinable date
or upon an event certain to occur. Management believes that the provisions of
SFAS No. 150 will not have a material impact on the Company's results of
operations and financial position upon adoption.

In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosures Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires that upon
issuance of a guarantee, the guarantor must recognize a liability for the fair
value of the obligation it assumes under that guarantee. FIN 45 is effective on
a prospective basis to guarantees issued or modified after December 15, 2002,
but has certain disclosure requirements effective for financial statements of
interim or annual periods ending after December 15, 2002. The Company does not
currently have any guarantees. The Company does not anticipate that the adoption
of the disclosure requirements of FIN 45 will have a material effect on its
financial position or results of operations.

RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001.

Revenues decreased by $454,000 or 43%, from $1,046,000 for the year ended
December 31, 2001 ("2001") to $592,000 for the year ended December 31, 2002
("2002"). License revenues decreased by $435,000 or 54%, from $809,000 for 2001
to $374,000 for 2002, primarily due to material reductions in sales and
marketing expenditures as well as material reductions in personnel in sales,
marketing and product development. Service revenues from maintenance and
training decreased by $19,000 or 9% from $237,000 in 2001 to $218,000 in 2002
resulting from decreased sales of the Company's software products and expiration
of licenses from sales generated in earlier periods. The Company's revenues from
customers in the United States represented 71% of its revenues in 2002 and 79%
of its revenues in 2001.

Cost of revenues consists of amortization of software development costs,
cost of licenses and cost of services. Cost of revenues increased $296,000 or
49%, from $607,000 for 2001 to $903,000 for 2002, representing 58% and 153% of
revenues, respectively. The increase in cost of revenues was primarily due to
increase of amortization of software development costs offset by reduction in
cost of services. Amortization of software development costs increased by
$364,000 or 97% from $377,000 for 2001 to $741,000 for 2002. The amortization of
software development costs includes the write-off of the unamortized balance of
capitalized software costs of $401,000 during 2002.

Cost of licenses consists of software media (disks) documentation, product
packaging, production costs and product royalties. Cost of licenses decreased
$15,000 or 50%, from $30,000 for 2001 to $15,000 for 2002, representing 4% of
license revenues for both years. The decrease in the cost of licenses resulted
primarily from material reduction in sales of software to end users.

Cost of services consists of salaries, benefits and overhead associated
with the technical support of maintenance contracts. Cost of services decreased
by $53,000 or 27%, from $200,000 for 2001 to $147,000 for 2002 primarily due to
the reduction of service personnel.

The gross profit decreased by $750,000 or 171%, from gross profit of
$439,000 for 2001, representing 42% of revenues, to gross loss of $(311,000) for
2002. The decrease

in gross profit was primarily due to a material decrease in sales of software
products along with a material increase in cost of revenues as described above.

Product development costs consists of salaries, benefits, bonuses, travel
and related costs of the Company's product development personnel, including
consulting fees, the costs of computer equipment used in product and technology
development. Product development expenses decreased by $610,000 or 28%, from
$2,209,000 for 2001 to $1,599,000 for 2002, representing 211% and 270% of
revenues, respectively. The decrease in product development costs was due
primarily to reduction of product development efforts, including layoffs and
office closings and decreased use of outside consultants. During 2001 and 2002,
the Company capitalized $313,000 and $180,000, respectively, of additional
software development costs associated with the development and enhancement of
its CYBERWALLPLUS family of products.

Sales and marketing expenses consist primarily of salaries, including
commissions, benefits, bonuses, travel, advertising, public relations,
consultants and trade shows. Sales and marketing expenses decreased by $820,000
or 31%, from $2,651,000 for 2001 to $1,831,000 for 2002, representing 253% and
309% of revenues, respectively. The decrease in sales and marketing expenses was
due primarily to a decrease of $608,000 in personnel and commission costs
related to the substantial head count reduction in 2002 and a $1,831,000
reduction in advertising and trade shows of $238,000.

General and administrative expenses include employee costs, including
salary, benefits, travel and other related expenses associated with management,
finance and accounting operations, and legal and other professional services
provided to the Company. General and administrative expenses decreased by
$39,000 or 2%, from $2,268,000 for 2001 to $2,229,000 for 2002, representing
217% and 376% of revenues for 2001 and 2002, respectively. The decrease in
general and administrative expenses in dollar amount was due primarily to an
increase of $261,000 in professional fees including accounting, legal and
business consulting which was partially offset by a decrease in personnel costs.
The increase in general and administrative expense as a percent of revenue was
due primarily to the material reduction in Company revenues for 2002.

Interest income decreased by $74,000 or 53% from $139,000 in 2001 to
$65,000 in 2002 primarily due to the increased funds used for operations and
decreased funds invested in short term instruments.

The discontinued operations were sold on February 9, 2000 to Exodus
Communications. The gain from discontinued operations in 2001 of $714,000 was
attributed to the contingent payouts received offset by related contingent
expenses pertaining to the sale paid in 2001.

No provision for or benefit from federal, state or foreign income taxes was
recorded for 2001 or 2002 since the Company incurred net operating losses for
each year and fully reserved its deferred tax assets as their future realization
could not be determined.

As a result of the foregoing, the net loss decreased by $2,130,000 or 27%,
from $8,035,000 for 2001 to $5,905,000 for 2002. The net loss for 2001 includes
a $2,163,000 charge for the beneficial conversion feature of the Company's
Series E Preferred Stock.

LIQUIDITY AND CAPITAL RESOURCES

As a result of discontinuing its product offerings in December 2002, the
Company has no revenue from operations. At December 31, 2002, the Company had
$2,029,000 of cash and cash equivalents and working capital of $1,110,000. The
Company has financed its operations primarily through sales of equity and debt
securities, and the sale of its professional services group. Net cash used in
operating activities was $4,947,000 during 2001 and $4,927,000 during 2002. Net
cash used in operating activities for 2002 was primarily attributable to the net
loss of $5,905,000, partially offset by the non-cash expense of $55,000
attributable to the issuance of options, depreciation and amortization expense
of $1,154,000 (which includes $661,000 for the write-off of capitalized software
costs and equipment and fixtures) offset in part by an increase in accounts
payable, accrued expenses and other current liabilities of $277,000. In May
2003, the Company received $415,000 from the sale of its CyberwallPlus
technology and related intellectual property.

The Company's operating activities during 2002 were financed primarily with
the funds raised in the 2001 Financing of $6,765,000. The Company does not
currently have a line of credit from a commercial bank or other institution.

The Company anticipates, based on currently proposed plans and assumptions,
that its cash balance of approximately $1,500,000 as of July 31, 2003 will be
sufficient to satisfy the Company's limited operations and capital requirements
until at least September 2004. There can be no assurance, however, that such
funds will not be expended prior thereto. In the event the Company's plans
change, or its assumptions change, or prove to be inaccurate (due to
unanticipated expenses, difficulties, delays or otherwise), the Company may have
insufficient funds to support its operations prior to September 2004. In the
third and fourth quarters of 2002, the Company instituted certain measures to
reduce its overhead including decreasing its headcount from 39 employees to its
current level of two employees and one consultant and the closing of its China
development office and its Taiwan sales office. In December 2002 the Company
discontinued its product offering in order to preserve cash as the Company
continues to seek a merger transaction. In May 2003, the Company completed the
sale of its CyberwallPlus technology and related intellectual property for an
aggregate consideration of $415,000. The Company is actively engaged in seeking
merger candidates. There is, however, no assurance that the Company will
consummate a merger transaction, or that any such merger will be successful. The
inability of the Company to consummate a merger transaction would have a
material adverse effect on the Company. In addition, a merger transaction is
likely to involve substantial dilution to the interests of the Company's
existing stockholders.

ITEM 7. FINANCIAL STATEMENTS

The financial statements required hereby are located on pages F-1 through
F-22 which follow Part III.

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

None.

PART III

ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.

NAME AGE POSITION
---- --- --------

Edward James 55 Interim Chief Executive Officer,
Chief Financial Officer and
Director

Corey M. Horowitz 48 Chairman of the Board of Directors
and Secretary

Harry B. Schessel 39 Director

EDWARD JAMES, age 55, has served as Interim Chief Executive Officer and
Chief Financial Officer of the Company since January 2003. In December 2002, Mr.
James became a director of the Company. During the period February 2002 until
January 2003, Mr. James was a financial consultant to the Company. Since 1993,
he has been an independent financial consultant for various companies, venture
capital firms and investors. Mr. James serves as interim Chief Executive Officer
and Chief Financial Officer of the Company on a part-time basis as he continues
to serve as a financial consultant to other companies and individuals.

COREY M. HOROWITZ, AGE 48, became Chairman of the Board of Directors of the
Company in January 1996 and has been a member of the Board of Directors since
April 1994. In January 2003, Mr. Horowitz also became Secretary of the Company.
Mr. Horowitz is a private investor and President and sole shareholder of CMH
Capital Management Corp., a New York investment advisory and merchant banking
firm, which he founded in September 1991. From January 1986 to February 1991,
Mr. Horowitz was a general partner in charge of mergers and acquisitions at
Plaza Securities Co., a New York investment partnership.

HARRY B. SCHESSEL, age 38, has been a director of the Company since July
2001. Since July 2002, Mr. Schessel has been a real estate developer. From July
2001 until July 2002, Mr. Schessel was employed at Kroll, Inc. ("Kroll") as the
Global Practice Leader for the Information Security Group. From June 2000 to
July 2001, Mr. Schessel advised security companies, including Kroll, in the
areas of strategy, operations, marketing and business development and also as a
consultant to investment banking firms and venture capital firms for purposes of
evaluating investments in the information security industry. From March 2000
until June 2000, Mr. Schessel was Vice President of Cybersafe, Inc., a security
software company. In June 1997, Mr. Schessel co-founded Centrax, Inc., a company
engaged in the development and marketing of intrusion detection software, and
was employed from June 1997 until its sale in March 1999 in various capacities,
including Chief Operating Officer and Executive Vice President.

MEETINGS AND COMMITTEES OF THE BOARD OF DIRECTORS

In August 1998, the Board of Directors established an Audit Committee and a
Compensation Committee. During 2002 the Audit Committee consisted of Harry
Schessel and Emanuel Pearlman, until Mr. Pearlman's resignation as a Director in
December 2002. Harry Schessel is currently the sole member of the Audit
Committee. The Audit Committee meets with the Company's independent auditors at
least annually to review the scope and results of the annual audit; reviews with
the Company's independent auditors the Company's quarterly reports on Form
10-QSB prior to filing, recommends to the Board the independent auditors to be
retained; and receives and considers the auditors' comments as to internal
controls, accounting staff and management performance and procedures in
connection with audit and financial controls. The Audit Committee has adopted a
written Audit Committee Charter. Emanuel Pearlman and Jonathan Mark served as
members of the Compensation Committee during 2002 until their resignations as
directors in December 2002. The Compensation Committee is also currently
composed of Harry Schessel. The Compensation Committee is responsible for
determining compensation for the executive officers of the Company, including
bonuses and benefits, and administration of the Company's compensation programs,
including the Company's Stock Option Plan.

The Board of Directors does not have a nominating committee. The selection
of nominees for the Board of Directors is made by the entire Board of Directors.
The Board of Directors may from time to time establish other committees to
facilitate the management of the Company.

During the past fiscal year, the Company's Board of Directors held 12
meetings. The Board of Directors' Compensation Committee met 6 times during the
past fiscal year. The Audit Committee met 5 times during the past fiscal year.
No incumbent director failed to participate in at least 75% of all meetings of
the Board of Directors and the committees on which he served during the past
fiscal year.

LIMITATION ON LIABILITY AND INDEMNIFICATION MATTERS

The Company's Certificate of Incorporation limits the liability of
directors to the maximum extent permitted by Delaware law. Delaware law provides
that directors of a corporation will not be personally liable for monetary
damages for breach of their fiduciary duties as directors, except for liability
(i) for any breach of their duty of loyalty to the corporation or its
stockholders, (ii) for acts or omissions not in good faith or that involve
intentional misconduct or a knowing violation of law, (iii) for unlawful
payments of dividends or unlawful stock repurchases or redemptions as provided
in Section 174 of the Delaware General Corporation Law or (iv) for any
transaction from which the director derived an improper personal benefit. The
Company's Bylaws provide that the Company shall indemnify its directors,
officers, employees and agents to the fullest extent permitted by law. The
Company's Bylaws also permit the Company to secure insurance on behalf of any
officer, director, employee or other agent for any liability arising out of his
or her actions in such capacity. The Company currently maintains liability
insurance for its officers and directors. At present, there is no pending
material litigation or proceeding involving any director, officer, employee or
agent of the Company where indemnification will be required or permitted. The
Company is not aware of any threatened litigation or proceeding that might
result in a material claim for such indemnification.

DIRECTOR COMPENSATION

The Company has compensated each director, who is not also an employee of
the Company, by granting to each outside director (upon joining the Board) stock
options to purchase 20,000 shares of Common Stock, at an exercise price equal to
the closing price of the Common Stock on the date of grant, with the options
vesting over a one year period in equal quarterly amounts. In addition, each
non-employee director receives an option grant to purchase 5,000 shares of
Common Stock for each year of service (after the first year) as a member of the
Board of Directors. Such options vest over a one year period in equal quarterly
amounts. In addition to the aforementioned option grants, directors may be
granted additional options in the discretion of the Board of Directors and the
Compensation Committee. In this regard, in January 2003 Harry Schessel and
Edward James each received options to purchase 55,000 and 30,000 shares of
Common Stock, respectively, at an exercise price of $.14 per share.

SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Section 16(a) of the Exchange Act requires the Company's executive
officers, directors, and persons who own more than 10% of the Company's
outstanding Common Stock to file initial reports of ownership and changes in
ownership with the Securities and Exchange Commission. Officers, directors and
greater than 10% stockholders are required by Commission regulations to furnish
the Company with copies of all Section 16(a) forms they file. The Company
believes that its executive officers, directors, and greater than 10%
stockholders complied during the year ended December 31, 2002 with the reporting
requirements of Section 16(a) except that Bradford Winkler, former Vice
President of Sales, inadvertently made a late Form 3 filing with the SEC on May
22, 2002 with respect to becoming an executive officer of the Company and
receipt of an option to purchase 200,000 shares of Common Stock. Mr. Winkler's
Form 3 filing was due on May 9, 2002.

ITEM 9A. CONTROLS AND PROCEDURES

Based on their evaluation, as of a date within 90 days of the filing of
this Form 10-KSB, the Company's Chief Executive Officer and Chief Financial
Officer have concluded that the Company's disclosure controls and procedures (as
defined in Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934)
are effective. There have been no significant changes in internal controls or in
other factors that could significantly affect these controls subsequent to the
date of their evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.

ITEM 10. EXECUTIVE COMPENSATION

The following table summarizes compensation, for the fiscal years
indicated, awarded to, earned by or paid to the Company's Chief Executive
Officer ("CEO") and to each of its executive officers, (collectively, the "Named
Executive Officers") who received annual salary and bonus in excess of $100,000
for the year ended December 31, 2002 for services rendered in all capacities to
the Company.

SUMMARY COMPENSATION TABLE
ANNUAL COMPENSATION LONG TERM COMPENSATION AWARDS
------------------- -----------------------------
SHARES
YEAR ENDED OTHER ANNUAL UNDERLYING ALL OTHER ANNUAL
NAME AND PRINCIPAL POSITION DECEMBER 31 SALARY ($) BONUS ($) COMPENSATION(1) OPTIONS(#) COMPENSATION(1)
--------------------------- ----------- ---------- --------- --------------- ---------- ---------------

Richard J. Kosinski 2002 $162,161(2) -- -- 1,200,000 --
President and Chief 2001 -- -- -- -- --
Executive Officer 2000 -- -- -- -- --

Murray P. Fish 2002 $193,000(3) -- -- -- --
President 2001 $169,356 $62,613 -- 156,254 --
Chief Financial Officer 2000 $138,461 $17,713 -- 30,000 --
and Secretary

Joseph A. Donohue 2002 $150,000(4) -- $2885 -- --
Vice President of 2001 $150,000 $21,488 -- 45,280 --
Engineering 2000 $138,462 $16,588 -- 30,000 --

Alex Chen 2002 $188,215(5) -- -- 150,000 --
Vice President and General 2001 -- -- -- -- --
Manager Asia Pacific Operations 2000 -- -- -- -- --

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

(1) The Company has concluded that the aggregate amount of perquisites and
other personal benefits paid to each of the Named Executive Officers did
not exceed the lesser of ten percent (10%) of such individual's annual
salary and bonus for each fiscal year indicated or $50,000.

(2) In March 2002, Mr. Kosinski became Chief Executive Officer and President at
an annual salary of $200,000. Mr. Kosinski's employment was terminated by
the Company in January 2003.

(3) In June 2001, Mr. Fish assumed the office of President on an interim basis
and also continued to serve as Chief Financial Officer and Secretary. In
March 2002, the Company hired Richard J. Kosinski as President and Chief
Executive Officer and Mr. Fish continued to serve as Chief Financial
Officer and Secretary. Mr. Fish's employment as Chief Financial Officer was
terminated by the Company in January 2003.

(4) Mr. Donohue was no longer employed by the Company as of December 31, 2002.

(5) Mr. Chen was hired by the Company in January 2002. Mr. Chen was no longer
employed by the Company as of September 2002.

EMPLOYMENT CONTRACTS, TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
ARRANGEMENTS

On June 29, 2001, the Company entered into an employment agreement with
Murray P. Fish pursuant to which Mr. Fish agreed to serve as the Company's
President (on an interim basis) and Chief Financial Officer for a two year term
at an annual salary of $185,000 per annum, and was also eligible to receive a
cash bonus of up to $50,000 per annum. In the event Mr. Fish's employment
agreement was terminated "other than for cause" (as defined in the employment
agreement), he would be entitled to, among other things, a severance equal to
the lesser of (i) twelve (12) months base salary or (ii) the

remaining base salary for the balance of the term of the agreement. Mr. Fish
agreed not to disclose any confidential information of the Company during the
term of his employment or at any time thereafter and not to compete with the
Company during the term of his agreement and for a period of two years
thereafter, in the event of termination for cause. In January 2003, Mr. Fish
commenced litigation against the Company seeking $200,000 in severance, bonus
and other benefits allegedly due him under his employment agreement (See Item 3
- "Legal Proceedings"). Upon notice of the litigation, the Company terminated
Mr. Fish's employment for "cause" in accordance with the terms of his employment
agreement.

On March 4, 2002, the Company entered into an employment agreement with
Richard J. Kosinski pursuant to which Mr. Kosinski agreed to serve as the
Company's President and Chief Executive Officer for a two (2) year term at an
annual base salary of $200,000 per annum. Mr. Kosinski was also eligible to
receive bonus compensation of up to $150,000 per year upon the Company achieving
certain objectives. In addition, Mr. Kosinski was issued options to purchase
1,200,000 shares of the Company's Common Stock, at an exercise price of $1.65
per share, which vested as follows: 25% of the shares (300,000 shares) on March
11, 2003, and 6.25% (75,000 shares) at the end of each three month period for
the subsequent three years. In the event Mr. Kosinski's employment was
terminated by the Company "other than for cause" (as such term is defined in the
Employment Agreement) or by Mr. Kosinski for "Good Reason" (as such term is
defined in the Employment Agreement), Mr. Kosinski shall be entitled to (i) a
severance of nine (9) months base salary and (ii) the vesting all options that
would have vested within twelve (12) months of termination. Mr. Kosinski agreed
not to disclose any confidential information of the Company during the term of
his employment or at any time thereafter or to compete with the Company during
the term of his agreement and for a period of two years thereafter in the event
of "Termination for Cause" or without "Good Reason." In January 2003, Mr.
Kosinski commenced litigation against the Company seeking $200,000 in severance,
bonus and other benefits allegedly due him. Upon receipt of notice of the
litigation, the Company terminated Mr. Kosinski's employment for "cause" in
accordance with the terms of his employment agreement. In June 2003, following
the Company's termination of Mr. Kosinski's employment in January 2003, the
Company and Mr. Kosinski entered into a settlement agreement to resolve
litigation commenced by Mr. Kosinski relating to a dispute under his employment
agreement. (See Item 3 - "Legal Proceedings").

On April 29, 2002, the Company entered into an offer letter with Bradford
Winkler, pursuant to which Mr. Winkler agreed to serve as the Company's Vice
President of Sales on an at-will basis at an annual base salary of $150,000 per
annum. Mr. Winkler was also eligible to receive quarterly incentive compensation
of up to $12,500 per quarter upon the Company achieving certain objectives. In
addition, Mr. Winkler was issued options to purchase 200,000 shares of the
Company's Common Stock, at an exercise price of $1.14 per share, which vested as
follows: 25% of the shares (50,000 shares) on April 29, 2003, and 6.25% (12,500
shares) at the end of each three month period for the subsequent three years. In
November 2002, Mr. Winkler's employment was terminated by the Company and he
received a severance of six months base salary in accordance with the terms of
his offer letter.

OPTION GRANTS IN 2002

The following stock options were granted to each of the Named Executive
Officers during the year ended December 31, 2002:

NUMBER OF
SHARES % OF TOTAL EXERCISE
UNDERLYING OPTIONS GRANTED TO PRICE PER EXPIRATION
OPTIONS GRANTED EMPLOYEES IN 2002(1) SHARE(2) DATE
--------------- -------------------- -------- ----

Richard J. Kosinski 957,600(3) 69% $1.65 3/11/12
242,400(3)

Murray P. Fish -0- -- -- --

Joseph Donohoe -0- -- -- --

Alex Chen 150,000(4) 9% $1.84 1/7/12

---------------------------
(1) The number of options granted to employees during the year ended December
31, 2002 used to compute this percentage is based on 792,400 incentive
stock options and 957,600 non-qualified stock options.

(2) All options were granted at an exercise price equal to the fair market
value of the Company's Common Stock at the date of grant, as determined by
the Board of Directors.

(3) In June 2003, Mr. Kosinski agreed to forfeit all of these options in
accordance with a settlement agreement reached with the Company (See Item 3
"Legal Proceedings").

(4) In October 2002, the options granted to Mr. Chen expired unexercised.

FISCAL YEAR-END OPTION VALUES

No options were exercised by any of the Named Executive Officers during the
year ended December 31, 2002. The following table sets forth information
relating to the fiscal year-end value of unexercised options held by Named
Executive Officers on an aggregated basis:

Number of Securities Underlying Value of Unexercised
Unexercised Options In-the-Money Options
at 12/31/2002 at Fiscal Year-End ($)(1)

Name Exercisable Unexercisable Exercisable Unexercisable
---- ----------- ------------- ----------- -------------

Richard J. Kosinski -0- 1,200,000(2) $-0- $-0-

Murray P. Fish(3) 220,815 60,454 $-0- $-0-

Joseph Donohue(4) 114,519 51,880 $-0- $-0-

Alex Chen -0- -0- $-0- $-0-

------------------------
(1) Options are "in-the-money" if the market price of the Common Stock on
December 31, 2002 ($.14) exceeds the exercise price of such options. The
value of such options is calculated by determining the difference between
the aggregate market price of the Common Stock underlying the options on
December 31, 2002 and the aggregate exercise price of such options.

(2) Pursuant to a settlement agreement reached in June 2003, Mr. Kosinski
agreed to forfeit these options (See Item 3 - "Legal Proceedings").

(3) All of the options held by Mr. Fish expired unexercised in February 2003
following the termination of Mr. Fish's employment except for non-qualified
stock options to purchase 100,000 shares of Common Stock.

(4) All of these options held by Mr. Donohue expired unexercised in January
2003 following the termination of Mr. Donohue's employment.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth information regarding the beneficial
ownership of the Company's shares of Common Stock and Preferred Stock (the
"Voting Stock") as of August 31, 2003 (i) each person known by the Company to be
the beneficial owner of more than 5% of the outstanding shares of Voting Stock,
(ii) each director and nominee, (iii) each of the executive officers of the
Company, and (iv) all executive officers and directors of the Company as a
group.

NAME AND ADDRESS(1) OF NUMBER OF SHARES PERCENTAGE OF SHARES
BENEFICIAL OWNER BENEFICIALLY OWNED BENEFICIALLY OWNED(2)
---------------- ------------------ ---------------------

Barry Rubenstein(3) 5,523,257 35%
FalconStor Software, Inc.(4) 4,839,740 29.6%
Irwin Lieber (5) 2,882,382 19.8%
Barry Fingerhut (6) 2,792,978 19.3%
Corey M. Horowitz(7) 1,839,749 12.4%
CMH Capital Management Corp.
Wheatley Partners II, L.P. (8) 1,572,015 11.3%
Woodland Venture Fund(9) 1,305,072 9.1%
Seneca Ventures(10) 946,347 6.7%
Edward James(11) 12,500 *
Harry B. Schessel(12) 33,750 *
All officers and directors
as a group 1,885,999 12.7%
(3 Persons)
------------------------
* Less than 1%.

(1) Except as otherwise indicated, the address for each beneficial owner is c/o
Network-1 Security Solutions, Inc., 445 Park Avenue, Suite 1028, New York,
New York 10022

(2) Unless otherwise indicated, the Company believes that all persons named in
the above table have sole voting and investment power with respect to all
shares of Voting Stock beneficially owned by them. A person is deemed to be
the beneficial owner of securities that can be acquired by such person
within 60 days from the date hereof upon the exercise of options, warrants
or convertible securities. Each beneficial owner's percentage ownership is
determined by assuming that options, warrants and convertible securities
held by such person (but not those held by any other person except for
outstanding shares of Preferred Stock) and which are exercisable or
convertible within 60 days have been exercised and converted. Assumes a
base of 13,672,952 shares of Voting Stock including (i) 8,314,458 shares of
outstanding Common Stock (ii) 4,967,016 shares of Common Stock issuable
upon conversion of 2,495,300 outstanding shares of Series E Preferred Stock
and (iii) 391,478 shares of Common Stock issuable upon conversion of
231,054 shares of outstanding Series D Preferred Stock.

(3) Includes (i) 1,194,659 shares of Common Stock, 188,678 shares of Common
Stock issuable upon conversion of Series E Preferred Stock and 188,678
shares of Common Stock subject to currently exercisable warrants held by
Wheatley Partners II,L.P., (ii) 173,584 shares of Common Stock issuable
upon conversion of Series E Preferred Stock and 173,584 shares of Common
Stock subject to currently exercisable warrants held by Wheatley Partners,
L.P., (iii) 15,094 shares of Common Stock issuable upon conversion of
Series E Preferred Stock and 15,094 shares of Common Stock subject to
currently exercisable warrants held by Wheatley Foreign Partners, L.P.,
(iv) 31,040 shares of Common Stock held by Mr. Rubenstein, (v) 47,500
shares of common stock subject to currently exercisable stock options held
by Mr. Rubenstein, (vi) 151,628 and 133,780 shares of Common Stock held by
Woodland Venture Fund and Seneca Ventures, respectively, (vii) 424,528,
330,188, 235,848, 188,678 and 94,338 shares of Common Stock issuable upon
conversion of Series E Preferred Stock held by Woodland Venture Fund,
Seneca Ventures, Brookwood Partners, L.P., Woodland Partners and Barry
Rubenstein, respectively, (viii) 611,366, 423,605, 282,095, 235,848,
145,335 and 1,333 shares of common stock subject to currently exercisable
warrants held by Woodland Venture Fund, Seneca Ventures, Woodland Partners,
Brookwood Partners, L.P., Barry Rubenstein and Marilyn Rubenstein,
respectively and (ix) 117,550, 58,774, 58,774, 839 and 839 shares of Common
Stock issuable upon conversion of Series D Preferred Stock held by Woodland
Venture Fund, Seneca Ventures, Woodland Partners, Barry Rubenstein and
Marilyn Rubenstein, respectively. Does not include options to purchase
11,875 shares of Common Stock held by Mr. Rubenstein which are not
currently exercisable. Barry Rubenstein is a general partner of Wheatley
Partners II, L.P. and a member of the general partner of each of Wheatley
Partners, L.P. and Wheatley Foreign Partners, L.P. Barry Rubenstein and
Woodland Services Corp. are the general partners of Woodland Venture Fund
and Seneca Ventures. Barry Rubenstein is the President and sole director of
Woodland Services Corp. Marilyn Rubenstein is the wife of Barry Rubenstein.
Mr. Rubenstein disclaims beneficial ownership of the shares of Common Stock
held by Wheatley Partners II, L.P., Wheatley Partners, L.P. and Wheatley
Foreign Partners, L.P., except to the extent of his equity interest
therein. The address of Barry Rubenstein is 68 Wheatley Road, Brookville,
New York 11545. The address of Wheatley Partners II, L.P. and Wheatley
Partners, L.P. is 60 Cuttermill Road, Great Neck, New York 11021. The
address of Wheatley Foreign Partners, L.P. is c/o Fiduciary Trust, One
Capital Place, Snedden Road, P.O. Box 162, Grand Cayman, British West
Indies. The address for Woodland Venture Fund, Seneca Ventures, Brookwood
Partners, L.P. and Woodland Partners is c/o Barry Rubenstein, 68 Wheatley
Road, Brookville, New York 11545.

(4) Includes (i) 2,169,870 shares of Common Stock issuable upon conversion of
Series E Preferred Stock and (ii) 2,669,870 shares of Common Stock subject
to currently exercisable warrants. FalconStor Software, Inc. has agreed to
vote all of its Preferred Stock (and any subsequent common stock owned by
it) in the same manner as voted by the holders of a majority of the Series
E Preferred Stock so long as the holders of the outstanding shares of
Series E Preferred Stock own at least 10% of the voting stock of the
Company. The address of FalconStor Software, Inc. is 125 Baylis Road,
Melville, New York 11747.

(5) Includes (i) 1,194,659 shares of Common Stock, 188,678 shares of Common
Stock issuable upon conversion of Series E Preferred Stock and 188,678
shares of Common Stock subject to currently exercisable warrants held by
Wheatley Partners II,L.P., (ii) 173,584 shares of Common Stock issuable
upon conversion of Series E Preferred Stock and 173,584 shares of Common
Stock subject to currently exercisable warrants held by Wheatley Partners,
L.P., (iii) 15,094 shares of Common Stock issuable upon conversion of
Series E Preferred Stock and 15,094 shares of Common Stock subject to
currently exercisable warrants held by Wheatley Foreign Partners, L.P.,
(iv) 23,280 shares of Common Stock owned by Mr. Lieber, (v) 47,500 shares
of Common Stock subject to

currently exercisable stock options owned by Mr. Lieber, (vi) 330,188
shares of Common Stock issuable upon conversion of Series E Preferred Stock
owned by Mr. Lieber, (vii) 58,774 shares of Common Stock issuable upon
conversion of Series D Preferred Stock owned by Mr. Lieber, and (viii)
473,269 shares of Common Stock subject to currently exercisable warrants
owned by Mr. Lieber. Does not include options to purchase 11,875 shares of
Common Stock owned by Mr. Lieber which are not currently exercisable. Mr.
Lieber disclaims beneficial ownership of the shares of Common Stock held by
Wheatley Partners II, L.P., Wheatley Partners, L.P. and Wheatley Foreign
Partners, L.P., except to the extent of his equity interest therein. The
address of Irwin Lieber is c/o Wheatley Partners, II, L.P., 80 Cuttermill
Road, Great Neck, New York 11021.

(6) Includes (i) 1,194,659 shares of Common Stock, 188,678 shares of Common
Stock issuable upon conversion of Series E Preferred Stock and 188,678
shares of Common Stock subject to currently exercisable warrants held by
Wheatley Partners II, L.P., (ii) 173,584 shares of Common Stock issuable
upon conversion of Series E Preferred Stock and 173,584 shares of Common
Stock subject to currently exercisable warrants held by Wheatley Partners,
L.P., (iii) 15,094 shares of Common Stock issuable upon conversion of
Series E Preferred Stock and 15,094 shares of Common Stock subject to
currently exercisable warrants held by Wheatley Foreign Partners, L.P.,
(iv) 31,040 shares of Common Stock owner by Mr. Fingerhut, (v) 330,188
shares of Common Stock issuable upon conversion of Series E Preferred Stock
owned by Mr. Fingerhut, (vi) 58,774 shares of Common Stock issuable upon
conversion of Series D Preferred Stock owned by Mr. Fingerhut, and (vii)
423,605 shares of Common Stock subject to currently exercisable warrants
owned by Mr. Fingerhut. Mr. Fingerhut disclaims beneficial ownership of the
shares of Common Stock held by Wheatley Partners II, L.P., Wheatley
Partners, L.P. and Wheatley Foreign Partners, L.P., except to the extent of
his equity interest therein. The address of Barry Fingerhut is c/o Wheatly
Partner, II, L.P., 80 Cuttermill Road, Great Neck, New York 11021.

(7) Includes (i) 486,303 shares of Common Stock held by Mr. Horowitz, (ii)
42,500 shares of Common Stock subject to currently exercisable stock
options held by Mr. Horowitz, (iii) 155,463 shares of Common Stock held by
CMH Capital Management Corp. ("CMH"), (iv) 924,936 shares of Common Stock
subject to currently exercisable warrants held by CMH, (v) 85,220 shares of
Common Stock subject to currently exercisable warrants held by Mr.
Horowitz, (vi) 70,754 shares of Common Stock issuable upon conversion of
Series E Preferred Stock, 70,754 shares of Common Stock subject to
currently exercisable warrants and 1,528 shares of Common Stock, all owned
by Donna Slavitt, the wife of Mr. Horowitz and (vii) 2,291 shares of Common
Stock held by Horowitz Partners, a general partnership of which Mr.
Horowitz is a partner. Does not include warrants and options to purchase
510,625 shares of Common Stock which are not currently exercisable. The
address of CMH Capital Management Corp. is 445 Park Avenue, New York, New
York 10022.

(8) Includes (i) 1,194,659 shares of Common Stock, (ii) 188,678 shares of
Common Stock issuable upon conversion of Series E Preferred Stock and (iii)
188,678 shares of Common Stock subject to currently exercisable warrants.
Does not include (i) 316,448, 23,280, 31,040, 4,656 and 3,104 shares of
Common Stock beneficially owned by Barry Rubenstein, Irwin Lieber, Barry
Fingerhut, Seth Lieber and Jonathan Lieber, respectively, each of whom is a
general partner of Wheatley Partners II, L.P. and (ii) an aggregate of
7,140,407 shares of Common Stock subject to currently exercisable warrants,
options, Series D Preferred Stock and Series E Preferred Stock beneficially
owned by Barry Rubenstein (3,634,794 shares), Irwin Lieber (1,287,087
shares), Barry Fingerhut (1,189,923 shares), Jonathan Lieber (604,079
shares) and Seth Lieber (424,524 shares). Each of Messrs. Rubenstein, I.
Lieber, Fingerhut, J. Lieber and S. Lieber disclaims beneficial ownership
of the securities held by Wheatley Partners II, L.P., except to the extent
of their equity interest therein.

Jonathan Lieber and Seth Lieber each beneficially owns less than 1% of the
outstanding Voting Stock of the Company exclusive of shares beneficially
owned by Wheatley Partners II, L.P., Wheatley Partners, L.P. and Wheatley
Foreign Partners, L.P. and as such have not been included in the beneficial
ownership table. Wheatley Partners II, L.P.'s business address is 80
Cuttermill Road, Great Neck, New York 11021.

(9) Includes (i) 151,628 shares of Common Stock, (ii) 424,528 shares of Common
Stock issuable upon conversion of Series E Preferred Stock, (iii) 611,366
shares of Common Stock subject to currently exercisable warrants and (iv)
117,550 shares of Common Stock issuable upon conversion of Series D
Preferred Stock. Woodland Venture Fund's business address is 68 Wheatley
Road, Brookville, New York 11546.

(10) Includes (i) 133,780 shares of Common Stock, (ii) 330,188 shares of Common
Stock issuable upon conversion of Series E Preferred Stock, (iii) 423,605
shares of Common Stock subject to currently exercisable warrants, and (iv)
58,774 shares of Common Stock issuable upon conversion of Series D
Preferred Stock. Seneca Venture's business address is 68 Wheatley Road,
Brookville, New York 11546.

(11) Includes 12,500 shares of Common Stock subject to currently exercisable
stock options issued to Mr. James pursuant to the Stock Option Plan. Does
not include 37,500 shares of Common Stock subject to stock options which
are not currently exercisable.

(12) Includes 33,750 shares of Common Stock subject to currently exercisable
stock options issued to Mr. Schessel pursuant to the Stock Option Plan.
Does not include 41,250 shares of Common Stock subject to stock options
which are not currently exercisable.

The Equity Compensation Plan information presented in Item 5 of this Annual
Report is incorporated herein in its entirety.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Since June 2001 the Company has paid CMH Capital Management Corp ("CMH") a
monthly fee of $17,500 and issued to CMH warrants to purchase an aggregate of
1,300,000 shares of Common Stock (at exercise prices ranging from $.70 per share
to $1.48 per share) in consideration for financial advisory and consulting
services rendered. CMH continues to render financial advisory and consulting
services to the Company on a month-to-month basis and receive the aforementioned
cash compensation. Corey M. Horowitz, Chairman of the Board of Directors and a
principal stockholder of the Company, is the sole officer, director and
stockholder of CMH. In addition, in connection with such financial advisory and
consulting services, CMH was reimbursed for expenses during 2001 and 2002 in the
amount of $44,000 and $51,000, respectively, including the allocable portion of
rent for office space in New York City.

In February 2003, the Company closed its principal offices in Waltham,
Massachusetts and moved its principal offices to space in New York City occupied
by CMH. Network-1 pays CMH rent on a month to month basis of $2,700 per month
for its New York City office.

During 2002, Edward James was paid consulting fees of $68,164 by the
Company. In December 2002 Mr. James became a Director of the Company and was
elected interim Chief Executive Officer and Chief Financial Officer in January
2003. Since January 2003 Mr. James has been paid $12,500 per month for his
services as interim Chief Executive Officer and Chief Financial Officer.

On October 2, 2001, the Company completed a private offering of $6,765,000
of preferred stock and warrants to a group of investors (the "October 2001
Offering"). The October 2001 Offering included the issuance of 3,191,037 shares
of our Series E Preferred Stock at $2.12 per share and warrants to purchase
6,882,074 shares of the Company's common stock at an exercise price of $1.27 per
share, subject to certain adjustments. Such warrants expire on October 2, 2003.
Each share of Series E Preferred Stock is convertible into two shares of common
stock, subject to certain adjustments. Investors in the October 2001 Offering
included FalconStor Software Inc. ($2,300,000), Barry Rubenstein and affiliated
entities, ($1,400,000), Wheatley Partners II, L.P. and related entities
($400,000), Irwin Lieber ($350,000) and Barry Fingerhut ($350,000), all
principal stockholders of the Company, and Donna Slavitt ($75,000), the wife of
Corey M. Horowitz, Chairman of the Board of Directors of the Company and a
principal stockholder of the Company.

On October 2, 2001, simultaneously with the closing of the October 2001
Offering, the Company entered into a ten (10) year Distribution and License
Agreement with FalconStor Software, Inc. ("FalconStor"), pursuant to which
FalconStor has the right to distribute the Company's product offerings in its
indirect and OEM channels. As part of the Distribution and License Agreement,
FalconStor paid the Company a non-refundable advance of $500,000 against future
royalty payments. On May 30, 2003, as part of the Company's sale of its
CyberwallPlus technology and related intellectual property to an unaffiliated
third party, the Company assigned its rights under the agreement with FalconStor
to the unaffiliated third party.

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

NO. DESCRIPTION

3.1 Certificate of Incorporation, as amended. Previously filed as
Exhibit 3.1 to the Company's Registration Statement on Form SB-2
(Registration No. 333-59617), declared effective by the SEC on
November 12,1998 (the "1998 Registration Statement"), and
incorporated herein by reference.

3.1.1 Certificate of Amendment to the Certificate of Incorporation
dated November 27, 2001. Previously filed as Exhibit 3.1.1 to the
Company's Registration Statement on Form S-3 (Registration No.
333-81344) declared effective by the SEC on February 12, 2002,
and incorporated herein by reference (the "February 2002 Form
S-3")

3.2 Certificate of Designations of Series D Preferred Stock.
Previously filed as Exhibit 3.1 to the Company's current report
on Form 8-K filed January 5, 2000 and incorporated herein by
reference.

3.3 Certificate of Designations of Series E Preferred Stock.
Previously filed as Exhibit 3.1 to the Company's current report
on Form 8-K filed October 12, 2001 (the "October 2001 Form 8-K")
and incorporated herein by reference.

3.4 By-laws, as amended. Previously filed as Exhibit 3.2 to the 1998
Registration Statement and incorporated herein by reference.

4.1 Form of Common Stock certificate. Previously filed as Exhibit 4.1
to the 1998 Registration Statement and incorporated herein by
reference.

10.1 Securities Purchase Agreement, dated as of October 2, 2001,
between the Company and the investors listed therein. Previously
filed as Exhibit 10.21 to the October 2001 Form 8-K and
incorporated herein by reference.

10.2 Form of Warrant, dated October 2, 2001, issued by the Company to
the holder listed thereon. Previously filed as Exhibit B to
Exhibit 10.21 to the October 2001 Form 8-K and incorporated
herein by reference.

10.3 Financial Advisory and Investment Banking Agreement, dated
December 1, 2001, by and between EarlyBirdCapital, Inc. and the
Company. Previously filed as Exhibit 10.3 to the October 2002
Form S-3 and incorporated by reference herein.

10.4 Agreement dated, January 29, 2002, between the Company and CMH
Capital Management Corp. relating to extension of the consulting
agreement. Previously filed as Exhibit 10.4 to the October 2002
Form S-3 and incorporated by reference herein.

10.5 Employment Agreement, dated June 29, 2001, between the Company
and Murray P. Fish. Previously filed as Exhibit 10.19 to the
Company's 10-QSB for the quarterly period ended June 30, 2002.

10.6 Employment Agreement, dated March 4, 2002, between the Company
and Richard J. Kosinski. Previously filed as Exhibit 10.6 to the
Company's current report on Form 8-K filed March 25, 2002 and
incorporated herein by reference.

10.7** License and Distribution Agreement between the Company and
FalconStor Software, Inc. Previously filed as Exhibit 10.21 to
October 2001 Form 8-K and incorporated herein by reference.

10.8 Extension of Consulting Agreement, dated July 2, 2002, between
the Company and CMH Capital Management Corp. previously filed as
Exhibit 10.8 to the Company's Quarterly Report on Form 10-QSB for
the period ended June 30, 2002 and incorporated herein by
reference.

10.9 Assignment Agreement, dated May 20, 2003, between the Company and
Trend Micro Incorporated (including exhibits). Previously filed
as Exhibit 10.8 to the Company's Current Report on Form 8-K filed
June 2, 2003 and incorporated herein by reference.

23.1* Consent of Eisner LLP, independent certified public accountants.

31.1* Controls and Procedure Certification of Chief Executive Officer
and Chief Financial Officer dated as of September 24, 2003.

32.1* Certification of Interim Chief Executive Officer and Chief
Financial Officer dated September 24, 2003.

--------------------------------------------------------------------------------
* Filed herewith.

** Confidentiality treatment has been granted for certain provisions.

(b) Reports on Form 8-K

On November 12, 2002, the Company filed a current report on Form 8-K with
respect to issuing a press release announcing strategic alternatives with
respect to its CyberwallPlus technology and its focus on a merger transaction.

SIGNATURES

In accordance with the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, in the City of
Framingham, Commonwealth of Massachusetts, on the 24 day of September 2003.

NETWORK-1 SECURITY SOLUTIONS, INC.

By /s/ Edward James
--------------------------------------
Edward James
Interim Chief Executive Officer
and Chief Financial Officer

In accordance with the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant caused this report to be signed
on its behalf by the following persons in the capacities and on the dates
indicated:

NAME TITLE DATE
---- ----- ----

/s/ Edward James Interim Chief Executive Officer, Chief Financial Officer and September 24, 2003
------------------------- Director (principal executive officer, principal financial
Edward James officer and principal accounting officer.)

/s/ Corey M. Horowitz Chairman of the Board of Directors September 24, 2003
-------------------------
Corey M. Horowitz

NETWORK-1 SECURITY SOLUTIONS, INC.

CONTENTS

PAGE
----

INDEX TO FINANCIAL STATEMENTS

Independent auditors' report F-2

Balance sheets as of December 31, 2002 and 2001 F-3

Statements of operations for the years ended December 31,
2002 and 2001 F-4

Statements of stockholders' equity for the years ended December 31,
2002 and 2001 F-5

Statements of cash flows for the years ended December 31,
2002 and 2001 F-6

Notes to financial statements F-7

F-1

INDEPENDENT AUDITORS' REPORT

Board of Directors and Stockholders
Network-1 Security Solutions, Inc.
New York, New York

We have audited the accompanying balance sheets of Network-1 Security Solutions,
Inc. (the "Company") as of December 31, 2002 and 2001 and the related statements
of operations, stockholders' equity and cash flows for each of the years then
ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements enumerated above present fairly, in all
material respects, the financial position of Network-1 Security Solutions, Inc.
as of December 31, 2002 and 2001 and the results of its operations and its cash
flows for each of the years then ended in conformity with accounting principles
generally accepted in the United States of America.

As discussed in Notes A and L, the Company terminated substantially all of its
operations during December 2002 and in May 2003 sold its intellectual property.
Management plans are also described in Note A.

New York, New York
July 2, 2003

F-2

NETWORK-1 SECURITY SOLUTIONS, INC.

BALANCE SHEETS

DECEMBER 31,
------------------------------
2002 2001
------------ ------------

ASSETS
Current assets:
Cash and cash equivalents $ 2,029,000 $ 7,121,000
Accounts receivable - net of allowance for doubtful accounts of $0 and
$73,000, respectively 6,000 62,000
Prepaid expenses and other current assets 96,000 113,000
------------ ------------

Total current assets 2,131,000 7,296,000

Equipment and fixtures - net 22,000 319,000
Capitalized software costs - net 561,000
Security deposits 8,000 8,000
------------ ------------

$ 2,161,000 $ 8,184,000
============ ============

LIABILITIES
Current liabilities:
Accounts payable $ 193,000 $ 405,000
Accrued expenses and other current liabilities 610,000 675,000
Deferred revenue 218,000 245,000
------------ ------------

Total current liabilities 1,021,000 1,325,000
------------ ------------

Liability to be settled with equity instrument 55,000
------------

Commitments and contingencies

STOCKHOLDERS' EQUITY
Preferred stock - $.01 par value; 10,000,000 shares authorized;
Series D - convertible, voting, authorized 1,250,000 shares; 231,054
shares issued and outstanding at December 31, 2002 and 2001,
respectively, liquidation preference of $705,000 at December 31,
2002 and 2001, respectively 2,000 2,000
Series E - convertible, authorized 3,500,000 shares; 2,483,508 and
3,191,037 shares issued and outstanding at December 31, 2002 and 2001,
respectively, liquidation preference of $5,265,000 and $6,765,000 at
December 31, 2002 and 2001, respectively 25,000 32,000
Common stock - $.01 par value; authorized 50,000,000 shares;
8,314,458 and 6,781,374 shares issued and outstanding at December 31,
2002 and 2001, respectively 83,000 68,000
Additional paid-in capital 41,397,000 41,274,000
Accumulated deficit (40,422,000) (34,517,000)
------------ ------------

1,085,000 6,859,000

$ 2,161,000 $ 8,184,000
============ ============

SEE NOTES TO FINANCIAL STATEMENTS F-3

NETWORK-1 SECURITY SOLUTIONS, INC.

STATEMENTS OF OPERATIONS

YEAR ENDED
DECEMBER 31,
----------------------------
2002 2001
----------- -----------

Revenues:
Licenses $ 374,000 $ 809,000
Services 218,000 237,000
----------- -----------

Total revenues 592,000 1,046,000
----------- -----------

Cost of revenues:
Amortization and impairment of software development costs 741,000 377,000
Cost of licenses 15,000 30,000
Cost of services 147,000 200,000
----------- -----------

Total cost of revenues 903,000 607,000
----------- -----------

Gross (loss) profit (311,000) 439,000
----------- -----------

Operating expenses:
Product development costs 1,599,000 2,209,000
Selling and marketing 1,831,000 2,651,000
General and administrative 2,229,000 2,268,000
----------- -----------

Total operating expenses 5,659,000 7,128,000
----------- -----------

Loss from continuing operations before interest income (expense) (5,970,000) (6,689,000)
Interest income 65,000 139,000
Interest expense (27,000)
Interest expense - related parties (9,000)
----------- -----------

Loss from continuing operations (5,905,000) (6,586,000)

Gain on sale of discontinued operations, including $65,000 of interest income
on contingency payments received in 2001 714,000
----------- -----------

NET LOSS (5,905,000) (5,872,000)
Imputed dividend on preferred stock (2,163,000)
----------- -----------

NET LOSS ATTRIBUTABLE TO COMMON STOCKHOLDERS $(5,905,000) $(8,035,000)
=========== ===========

PER COMMON SHARE - BASIC AND DILUTED:
Loss from continuing operations $ (0.78) $ (1.35)
Income from discontinued operations .11
----------- -----------

Loss per share - basic and diluted $ (0.78) $ (1.24)
=========== ===========

WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING 7,584,911 6,471,056
=========== ===========

SEE NOTES TO FINANCIAL STATEMENTS F-4

NETWORK-1 SECURITY SOLUTIONS, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY

SERIES D CONVERTIBLE SERIES E CONVERTIBLE
PREFERRED STOCK PREFERRED STOCK
---------------------------- ---------------------------
SHARES AMOUNT SHARES AMOUNT
------------ ------------ ------------ ------------

BALANCE - JANUARY 1, 2001 115,220 $ 1,000
Amortization of compensatory stock options and warrants
Charge for vesting of contingent options to former employees -
discontinued operations
Conversion of Series D preferred stock (8,197)
Conversion of notes and accrued interest into
Series D preferred stock 124,031 1,000
Conversion of notes and accrued interest into common stock
Issuance of warrants and options for services
Issuance of Series E preferred stock and warrants 3,191,037 $ 32,000
Offering costs of Series E preferred stock and warrants offering
Beneficial conversion feature of Series E preferred stock
Net loss
------------ ------------ ------------ ------------

BALANCE - DECEMBER 31, 2001 231,054 2,000 3,191,037 32,000
Conversion of Series E preferred stock (707,529) (7,000)
Exercise of Series E warrants
Exercise of Series D warrants
Net loss
------------ ------------ ------------ ------------

BALANCE - DECEMBER 31, 2002 231,054 $ 2,000 2,483,508 $ 25,000
============ ============ ============ ============

UNEARNED
PORTION OF
COMMON STOCK ADDITIONAL COMPENSATORY
---------------------------- PAID-IN STOCK OPTIONS
SHARES AMOUNT CAPITAL AND WARRANTS
------------ ------------ ------------ ------------
BALANCE - JANUARY 1, 2001 6,448,363 $ 65,000 $ 30,705,000 $ (107,000)
Amortization of compensatory stock options and warrants 107,000
Charge for vesting of contingent options to former employees - 230,000
discontinued operations
Conversion of Series D preferred stock 8,197
Conversion of notes and accrued interest into
Series D preferred stock 377,000
Conversion of notes and accrued interest into common stock 324,814 3,000 363,000
Issuance of warrants and options for services 545,000
Issuance of Series E preferred stock and warrants 7,083,000
Offering costs of Series E preferred stock and warrants offering (192,000)
Beneficial conversion feature of Series E preferred stock 2,163,000
Net loss
------------ ------------ ------------ ------------

BALANCE - DECEMBER 31, 2001 6,781,374 68,000 41,274,000
Conversion of Series E preferred stock 1,415,058 14,000 (7,000)
Exercise of Series E warrants 9,432 12,000
Exercise of Series D warrants 108,594 1,000 118,000
Net loss
------------ ------------ ------------ ------------

BALANCE - DECEMBER 31, 2002 8,314,458 $ 83,000 $ 41,397,000 $ 0
============ ============ ============ ============

ACCUMULATED
DEFICIT TOTAL
------------ ------------
BALANCE - JANUARY 1, 2001 $(26,482,000) $ 4,182,000
Amortization of compensatory stock options and warrants 107,000
Charge for vesting of contingent options to former employees - 230,000
discontinued operations
Conversion of Series D preferred stock 0
Conversion of notes and accrued interest into
Series D preferred stock 378,000
Conversion of notes and accrued interest into common stock 366,000
Issuance of warrants and options for services 545,000
Issuance of Series E preferred stock and warrants 7,115,000
Offering costs of Series E preferred stock and warrants offering (192,000)
Beneficial conversion feature of Series E preferred stock (2,163,000) 0
Net loss (5,872,000) (5,872,000)
------------ ------------

BALANCE - DECEMBER 31, 2001 (34,517,000) 6,859,000
Conversion of Series E preferred stock 0
Exercise of Series E warrants 12,000
Exercise of Series D warrants 119,000
Net loss (5,905,000) (5,905,000)
------------ ------------

BALANCE - DECEMBER 31, 2002 $(40,422,000) $ 1,085,000
============ ============

SEE NOTES TO FINANCIAL STATEMENTS F-5

NETWORK-1 SECURITY SOLUTIONS, INC.

STATEMENTS OF CASH FLOWS

YEAR ENDED
DECEMBER 31,
----------------------------
2002 2001
----------- -----------

CASH FLOWS FROM OPERATING ACTIVITIES:
Loss from continuing operations $(5,905,000) $(6,586,000)
Adjustments to reconcile loss from continuing operations to net cash
used in operating activities:
Interest expensed and converted to Series D convertible preferred stock 34,000
Issuance of options and warrants for services rendered 55,000 545,000
Provision for doubtful accounts (7,000)
Amortization of compensatory stock options 107,000
Depreciation, amortization and impairment charge 1,154,000 525,000
Changes in:
Accounts receivable 56,000 172,000
Prepaid expenses and other current assets 17,000 40,000
Accounts payable, accrued expenses and other current liabilities (277,000) 160,000
Interest payable (1,000)
Deferred revenue (27,000) 64,000
----------- -----------

Net cash used in operating activities (4,927,000) (4,947,000)
----------- -----------

CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions of equipment and fixtures (116,000) (30,000)
Capitalized software costs (180,000) (313,000)
Refund of security deposit 73,000
Proceeds from sale of discontinued operations, net 1,003,000
----------- -----------

Net cash (used in) provided by investing activities (296,000) 733,000
----------- -----------

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of options and warrants 131,000
Payments on note payable (13,000)
Proceeds from issuance of Series E convertible preferred stock and warrants 7,115,000
Offering costs (192,000)
----------- -----------

Net cash provided by financing activities 131,000 6,910,000
----------- -----------

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (5,092,000) 2,696,000
Cash and cash equivalents - beginning of year 7,121,000 4,425,000
----------- -----------

CASH AND CASH EQUIVALENTS - END OF YEAR $ 2,029,000 $ 7,121,000
=========== ===========

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest $ 2,000
Noncash transactions:
Issuance of common stock in connection with conversion of notes payable
and accrued interest $ 366,000
Issuance of preferred stock in connection with conversion of notes payable
and accrued interest $ 378,000

SEE NOTES TO FINANCIAL STATEMENTS F-6

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE A - THE COMPANY

Network-1 Security Solutions, Inc. (the "Company") developed, marketed, licensed
and supported its proprietary network security software products designed to
provide comprehensive security to computer networks. The Company also provided
maintenance and training services. The Company also provided consulting services
in network security and network design through its Professional Services Group,
which was sold in February 2000 and has been accounted for as a discontinued
operation (see Note G).

In December 2002, the Company discontinued its software product line and
associated operations, ceased its product development and substantially
eliminated its sales and marketing efforts and during May 2003, sold
substantially all of its intellectual property. Through a series of layoffs, the
Company has reduced its workforce to a current level of two employees and a
consultant. The Company has closed its various offices upon termination of
leases during 2002 and 2003 (see Notes L[3] and L[4]). Management is focusing
its efforts on seeking a merger candidate for the Company.

NOTE B - SIGNIFICANT ACCOUNTING POLICIES

[1] CASH EQUIVALENTS:

The Company considers all highly liquid short-term investments purchased
with a maturity of three months or less to be cash equivalents.

[2] REVENUE RECOGNITION:

License revenue is recognized upon delivery of software or delivery of a
required software key. License revenue from distributors or resellers is
recognized as the distributor or reseller delivers software or the
required software key to end users or original equipment manufacturers.
Service revenues consist of maintenance and training services. Annual
renewable maintenance fees are a separate component of each contract, and
are recognized ratably over the contract term. Training revenues are
recognized as such services are performed. Revenue from advance license
fees are deferred until they are earned pursuant to the agreements.

[3] EQUIPMENT AND FIXTURES:

Equipment and fixtures are stated at cost and are depreciated using the
straight-line method over their estimated useful lives of five years.

[4] SOFTWARE DEVELOPMENT COSTS:

Costs to maintain developed programs and development costs incurred to
establish the technological feasibility of computer software are expensed
as incurred. The Company capitalized costs incurred in producing computer
software after technological feasibility of the software has been
established through the date that the software is ready for general
release to customers. Such costs are amortized based on current and
estimated future revenue of each product with an annual minimum equal to
the straight-line amortization over the remaining estimated economic life
of the product. The Company estimates the economic life of its software to
be three years. At each balance sheet date, the unamortized capitalized
software costs of each product are compared with the estimated net
realizable value of that product and any excess capitalized costs are
written off.
F-7

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

[5] IMPAIRMENT OF LONG-LIVED ASSETS:

In accordance with Statement of Financial Accounting Standards ("SFAS")
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets",
the Company records impairment losses on long-lived assets used in
operations or expected to be disposed of when indicators of impairment
exist and the cash flows expected to be derived from those assets are less
than carrying amounts of those assets. During the year ended December 31,
2002, the Company recorded an impairment charge related to its network
security software of approximately $401,000, which has been included in
amortization of software development costs. Subsequently, in May 2003, the
Company sold its network security software (see Note L[4]). The Company
also reduced the carrying value of its fixed assets to their net
realizable amount (see Note C).

[6] INCOME TAXES:

The Company utilizes the liability method of accounting for income taxes.
Under such method, deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities
and their respective tax bases. Deferred tax assets and liabilities are
measured using enacted tax rates in effect at the balance sheet date. The
resulting asset or liability is adjusted to reflect enacted changes in tax
law. Deferred tax assets are reduced, if necessary, by a valuation
allowance when the likelihood of realization is not assured.

[7] LOSS PER SHARE:

Basic loss per share is calculated by dividing the net loss by the
weighted average number of outstanding common shares during the year.
Diluted per share data includes the dilutive effects of options, warrants
and convertible securities. Potential common shares of 18,081,581 and
18,311,543 at December 2002 and 2001, respectively, are anti-dilutive, and
are not included in the calculation of diluted loss per share. Such
potential common shares reflect options, warrants, convertible preferred
stock and convertible notes. For the year ended December 31, 2001, the
loss per share is increased by the value of the beneficial conversion
feature on the Series E preferred stock, which is accounted for as a
preferred stock dividend (see Note F).

[8] USE OF ESTIMATES:

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.

[9] FINANCIAL INSTRUMENTS:

The carrying amounts of cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses approximate their fair value due to
the short period to maturity of these instruments.

F-8

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

[10] STOCK-BASED COMPENSATION:

The Company accounts for stock-based employee compensation under
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees", and related interpretations. The Company has adopted
the disclosure-only provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation" and SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," which was released in December
2002 as an amendment of SFAS No. 123. The following table illustrates the
effect on net loss and loss per share if the fair value-based method had
been applied to all awards:

YEAR ENDED
DECEMBER 31,
----------------------------
2002 2001
----------- -----------

Reported net loss attributable to common stockholders $(5,905,000) $(8,035,000)
Stock-based employee compensation expense included
in reported net loss 26,000
Stock-based employee compensation determined under
the fair value-based method (298,000) (1,001,000)
----------- -----------

Pro forma net loss $(6,203,000) $(9,010,000)
=========== ===========

Loss per common share (basic and diluted):
As reported $ (0.78) $ (1.24)
=========== ===========

Pro forma $ (0.82) $ (1.39)
=========== ===========

The fair value of options on the date of grant is estimated using the
Black-Scholes option pricing model utilizing the following weighted
average assumptions:

YEAR ENDED
DECEMBER 31,
----------------------------
2002 2001
----------- -----------

Risk-free interest rates 2.63 - 6.44% 4.61%
Expected option life in years 6.60 6.60
Expected stock price volatility 112.00% 113.00%
Expected dividend yield 0.00% 0.00%

[11] ADVERTISING COSTS:

Advertising costs are expensed as incurred. Advertising expense was
$93,000 and $164,000 for the years ended December 31, 2002 and 2001,
respectively.

F-9

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

[12] RECENTLY ISSUED ACCOUNTING STANDARDS:

In May 2002, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 145, "Recession of FASB Statements No. 4, 44, and 64, Amendment of
FASB Statement No. 13, and Technical Corrections." SFAS No. 145 rescinds
the requirement that all gains and losses from extinguishment of debt be
classified as an extraordinary item. Additionally, SFAS No. 145 requires
that certain lease modifications that have economic effects similar to
sale-lease back transactions be accounted for in the same manner as
sale-lease back transactions. This statement is effective for the Company
beginning in 2003. Management has not yet determined what impact the
adoption of SFAS No. 145 will have on the Company's financial statements.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which addresses financial
accounting and reporting for costs associated with exit or disposal
activities and supersedes Emerging Issues Tax Force ("EITF") Issue 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity" (including "Certain Costs Incurred in a
Restructuring"). SFAS No. 146 requires that a liability for a cost
associated with an exit or disposal activity be recognized when the
liability is incurred. Under EITF Issue 94-3, a liability for an exit cost
as defined in EITF Issue 94-3 was recognized at the date of an entity's
commitment to an exit plan. SFAS No. 146 also establishes that the
liability should initially be measured and recorded at fair value. SFAS
No. 146 is effective for exit and disposal activities initiated after
December 31, 2002. Management is currently evaluating the provisions of
SFAS No. 146 but expects that it will not have a material impact on the
Company's results of operations and financial position upon adoption.

In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure." This statement
amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide
alternative methods of transition for an entity that changes to the fair
value method of accounting for stock-based employee compensation. In
addition, SFAS No. 148 amends the disclosure provisions of SFAS No. 123 to
require expanded and more prominent disclosures in annual financial
statements about the method of accounting for stock-based compensation and
the pro forma effect on reported results of applying the fair value method
for entities that use the intrinsic value method. The pro forma
disclosures are also required to be displayed prominently in interim
financial statements. The Company does not intend to change to the fair
value method of accounting and has included the disclosure requirements of
SFAS No. 148 in the accompanying financial statements.

SFAS No. 150, "Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity", which was issued in May
2003, will require redeemable preferred stock to be classified, in certain
circumstances, as a liability, upon adoption by a public company at the
beginning of the first interim period beginning after June 15, 2003. SFAS
No. 150 provides that mandatorily redeemable preferred stock should be
classified as a liability if it embodies an unconditional obligation
requiring the issuer to redeem the shares by transferring its assets at a
specified or determinable date or upon an event certain to occur.
Management believes that the provisions of SFAS No. 150 will not have a
material impact on the Company's results of operations and financial
position upon adoption.

In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosures Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires that
upon issuance of a guarantee, the guarantor must recognize a liability for
the fair value of the obligation it assumes under that guarantee. FIN 45
is effective on a prospective basis to guarantees issued or modified after
December 15, 2002, but has certain disclosure requirements effective for
financial statements of interim or annual periods ending after December
15, 2002. The Company does not currently have any guarantees. The Company
does not anticipate that the adoption of the disclosure requirements of
FIN 45 will have a material effect on its financial position or results of
operations.

F-10

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

[13] RECLASSIFICATION:

Certain prior year amounts have been reclassified to conform to the 2002
presentation.

NOTE C - EQUIPMENT AND FIXTURES

Equipment and fixtures are summarized as follows:

DECEMBER 31,
------------------------
2002 2001
--------- ---------
Office and computer equipment $ 649,000 $ 565,000
Furniture and fixtures 146,000 114,000
--------- ---------

795,000 679,000
Less accumulated depreciation (773,000) (360,000)
--------- ---------

$ 22,000 $ 319,000
========= =========

Depreciation expense was $413,000 and $148,000 for the years ended December 31,
2002 and 2001, respectively. Included in depreciation expense for the year ended
December 31, 2002 was a write-down of $260,000 to reduce the net book value of
fixed assets to the price they were sold for in January 2003.

NOTE D - CAPITALIZED SOFTWARE COSTS

YEAR ENDED
DECEMBER 31,
------------------------
2002 2001
--------- ---------

Balance, beginning of year (net of
accumulated amortization) $ 561,000 $ 625,000
Additions 180,000 313,000
Amortization (741,000) (377,000)
--------- ---------

Balance, end of year (net of
accumulated amortization) $ 0 $ 561,000
========= =========

During 2002, the Company wrote-off the remaining balance of $401,000
attributable to its capitalized software cost when it discontinued its software
product offering and is included in the current year's amortization of $741,000
(see Note B[5]).

NOTE E - NOTES PAYABLE

In December 1999, the Company raised $3,000,000 through the issuance of
convertible notes payable, Series D convertible preferred stock and warrants
(see Note F[1]).

F-11

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE E - NOTES PAYABLE (CONTINUED)

In December 1999, the Company issued $1,500,000 of convertible promissory notes
(the "Notes") bearing interest at 8%, which matured in December 2001 ($525,000
of which was payable to related parties). The Notes were convertible into
491,803 shares of Series D preferred stock of the Company (570,492 shares if
interest through the maturity of the Notes is considered) and an equal number of
five-year warrants to purchase 491,803 shares of common stock (570,492 shares if
interest through the maturity of the Notes is considered) at an exercise price
of $3.05 per share, subject to certain adjustments. The conversion price of the
Series D preferred stock ($1,500,000) and the exercise price of the warrants
($1,475,000) was less than the aggregate market price ($5,102,000) of the common
stock obtainable upon conversion and exercise on the closing date of the private
placement. Accordingly, upon approval of the conversion feature by a majority
vote of the stockholders of the Company in April 2000, the Company incurred an
interest charge of $1,500,000, representing the beneficial conversion feature of
the preferred stock, limited to the $1,500,000 proceeds received on the issuance
of the Notes.

During the year ended December 31, 2001, $339,000 of the Notes, including
$300,000 payable to related parties and $39,000 of accrued interest payable on
the Notes, including $36,000 payable to related parties were converted, at a
conversion price of $3.05 per share, into 124,031 shares of Series D convertible
preferred stock and an equal number of five-year warrants. An additional $30,000
of the Notes and $3,000 of accrued interest payable on the Notes were converted,
at a conversion price of $3.05 per share, into 10,897 shares of common stock and
an equal number of warrants. Pursuant to the Notes' anti-dilution provisions, as
a result of the Company's Series E preferred stock and warrant offering in
October 2001, the conversion price of the Series D preferred stock was changed
to $1.80, the conversion rate at which the Series D convertible preferred stock
may be converted into common stock was changed from 1:1 to 1:1.69431, and the
exercise price of the warrants outstanding at $3.05 and warrants to be issued
upon conversion of the Notes was changed to $1.114. In December 2001, $287,000
of the Notes and $46,000 of accrued interest were converted into 185,278 shares
of Series D convertible preferred stock and an equal number of warrants. The
Series D convertible preferred stock was simultaneously converted into 313,917
shares of common stock.

The remaining balance of $13,000 of the Notes that were not converted into
preferred or common stock, was paid to the noteholder, who was then a director
of the Company.

NOTE F - STOCKHOLDERS' EQUITY

[1] PREFERRED STOCK:

(a) Series D preferred stock:

Pursuant to the private placement discussed in Note E, in December
1999 the Company received $1,500,000 from the sale of 491,803 shares
of Series D convertible preferred stock at $3.05 per share, including
172,129 shares to related parties. Such stock is convertible into
common shares at a conversion rate of 1.69431 (as adjusted), has
identical voting rights as the Company's common stock, and is
entitled to equivalent dividend rights as those paid on shares of
common stock obtainable on conversion. The holders of the Series D
convertible preferred stock are entitled to a liquidation preference
of $3.05 per share plus any declared but unpaid dividends before any
payments are made to holders of common stock, and rank equal with
Series E preferred stock in the event of liquidation, dissolution or
winding up of the Company. In connection therewith, the Company also
issued five-year warrants to purchase 491,803 shares of common stock
at an exercise price of $3.05 per share. The exercise price of the
warrants was reduced to $1.00 because the Company did not achieve a
specified revenue target. Holders of warrants for 444,857 shares,
including 424,411 warrants obtained upon conversion of the Notes and
accrued interest (Note E), waived such exercise price reduction. Of
these warrants, 147,149 were exercised during 2000.

F-12

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)

[1] PREFERRED STOCK: (CONTINUED)

(a) Series D preferred stock: (continued)

Pursuant to anti-dilution features of the Series D convertible
preferred stock, convertible notes and warrants, in connection with
the October 2, 2001 private offering of Series E preferred stock and
warrants (see (b) below), the holders of (i) outstanding Series D
preferred stock, (ii) certain warrants to purchase common stock and
(iii) convertible notes (convertible into Series D preferred stock
and warrants) in the principal amount of $300,000, all issued in
connection with the Company's private offering completed in December
1999, received the right to receive 1,145,207 additional shares of
common stock (exclusive of conversion of interest with respect to the
convertible notes) upon conversion or exercise of Series D preferred
stock, convertible notes and warrants as a result of the
anti-dilution provisions of such securities. In addition, the
exercise price of outstanding warrants and warrants issuable upon
conversion of the promissory notes and accrued interest was adjusted
from $3.05 to $1.114.

(b) Series E preferred stock:

On October 2, 2001, the Company completed a $6,765,000 private
offering of Series E preferred stock ("Series E") and warrants (the
"2001 Financing"). An aggregate of 3,191,037 shares of Series E
together with warrants to purchase 6,882,074 shares of common stock
were sold. The warrants were issued at the rate of two warrants, each
to purchase a share of common stock at $1.27 per share, with every
share of Series E, plus an additional warrant to purchase 500,000
shares to an investor, Falconstor Software, Inc. ("Falconstor"), for
investing more than $2,000,000 (the "Additional Warrant"). In
connection with the 2001 Financing, the Company and Falconstor
entered into a ten-year License and Distribution Agreement (the
"Falconstor Agreement") pursuant to which Falconstor has the right to
distribute the Company's product offerings in its indirect and OEM
channels. As part of the Falconstor Agreement, Falconstor paid the
Company a non-refundable advance of $500,000 against future royalty
payments (the "Advance"). For accounting purposes, $350,000 of the
Advance, representing the estimated fair value of the Additional
Warrant was accounted for as its purchase price, resulting in total
proceeds attributable to the 2001 Financing of $7,115,000. For
accounting purposes, an allocation of $4,952,000 and $2,163,000 was
made to the Series E and warrants, respectively, based on the
relative fair values of the common stock obtainable upon conversion
of the Series E and the warrants on the date of the 2001 Financing.
The warrants were valued using the Black-Scholes option pricing model
using the following assumptions: volatility of 113.45%, expected life
of 1 year and 3 years, dividend yield of 0, and risk-free interest
rates of 2.47% and 3.14%, respectively. The difference between the
proceeds allocated to the Series E and the fair market value of the
common stock obtainable upon conversion of the Series E represents a
beneficial conversion feature, which has been imputed as a preferred
stock dividend in calculating the net loss available to common
stockholders. On May 30, 2003, as part of the Company's sale of its
CyberwallPLUS technology and related intellectual property (the
"Assets") to an unrelated third party (the "Purchaser"), the Company
assigned its rights under the Falconstor Agreement to the Purchaser
(see Note L[4]).

F-13

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)

[1] PREFERRED STOCK: (CONTINUED)

(b) Series E preferred stock: (continued)

Holders of the Series E may convert each such share into two shares
of common stock at any time, subject to adjustment. During the year
ended December 31, 2002, holders of 707,529 shares of Series E
converted their shares into 1,415,058 shares of common stock. The
Series E is entitled to vote on all matters with the holders of the
Company's common stock based on the number of shares of common stock
into which such shares may be converted, except that the holders of
the Series E have irrevocably waived any increased voting rights that
may be afforded to the holders of Series E resulting from
anti-dilution protection. Holders of Series E shall receive dividends
and other distributions, when, as and if declared by the Board of
Directors, out of funds legally available therefore equivalent to
those dividends paid on shares of common stock. The holders of Series
E will be entitled to a liquidation preference of $2.12 per share
plus any declared but unpaid dividends before any payments are made
to holders of common stock, and the Series E ranks equal with the
Series D preferred stock upon liquidation. The Company also agreed
with the holders of the Series E that, without the approval of the
Series E designee, a principal stockholder of the Company (see Note
K[4]), it will not take certain action, including (i) issue
securities except for securities issued under its stock option plan,
(ii) incur debt in excess of $250,000, (iii) enter into a merger,
acquisition or sale of substantially all of its assets and (iv) take
any action to amend its Certificate of Incorporation or By-laws that
could in any way adversely affect the rights of the holders of the
Series E. In addition, the investors were granted registration rights
with respect to the shares of common stock to be received upon
conversion of the Series E preferred stock and exercise of the
warrants.

[2] STOCK OPTIONS:

During 1996, the Board of Directors and stockholders approved the adoption
of the 1996 Stock Option Plan (the "1996 Plan"). The 1996 Plan, as
amended, provides for the granting of both incentive and non-qualified
options to purchase common stock of the Company. A total of 4,000,000
shares are available under the 1996 Plan.

The term of options granted under the 1996 Plan may not exceed ten years
(five years in the case of an incentive stock option granted to an
optionee owning more than 10% of the voting stock of the Company) ("10%
stockholder"). The option price for incentive stock options can not be
less than 100% of the fair market value of the shares of common stock at
the time the option is granted (110% for a 10% stockholder). Option terms
and vesting periods are set by the Compensation Committee in its
discretion.

F-14

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)

[2] STOCK OPTIONS: (CONTINUED)

The following table summarizes stock option activity for the years ended
December 31:

2002 2001
------------------------ ------------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
OPTIONS EXERCISE OPTIONS EXERCISE
OUTSTANDING PRICE OUTSTANDING PRICE
---------- ---------- ---------- ----------

Options outstanding at beginning of year 1,761,652 $3.36 1,602,842 $4.94
Granted 2,520,000(b) 1.48 900,595(a) 1.73
Exercised
Cancelled (1,127,154) 2.26 (741,785) 4.82
---------- ----------

Options outstanding at end of year 3,154,498 2.25 1,761,652(c) 3.36
========== ==========

Options exercisable at end of year 788,165 4.03 960,012 3.89
========== ==========

(a) Includes 265,095 options granted in January 2001, with an exercise
price of $3.06, the fair value of the common stock on the date of
grant, that vest 50% if the closing stock price of the Company's
common stock is at or above $10 per share for 8 out of 10 trading
days. The remaining 50% vest if the closing stock price is at or
above $15 per share for 8 out of 10 trading days. The options expire
in 10 years. Of such options, 26,250 were granted to consultants or
service providers. As the vesting of the options is contingent upon
the market price of the Company's common stock, but the services have
been provided, the valuation of the options, and accordingly the
expense recognized, is subject to adjustment based on, among other
factors, the market price on the date of the valuation. The Company
will estimate the value of the options' at each reporting date until
they have vested. In 2001, the Company recognized $32,000 of expense
based on the fair value of the options at December 31, 2001 using the
Black-Scholes option pricing model of valuation using the following
assumptions: volatility of 114%, risk-free interest rate of 5.07%,
dividend yield of 0 and an expected life of 8 years. No adjustment
was made for the year ended December 31, 2002, since the amount was
not significant.

(b) On April 18, 2002, in consideration of additional consulting and
financial advisory services, the Company issued to CMH Capital
Management Corp. ("CMH") an option to purchase 750,000 shares of the
common stock at an exercise price of $1.20 per share, which was the
market price of the Company's common stock on the date of issuance.
Corey M. Horowitz, Chairman of the Board of Directors of the Company,
is the sole owner and officer of CMH. The shares underlying the
option shall vest over a three-year period in equal amounts of
250,000 shares per year beginning April 18, 2003. In addition, the
shares underlying the option shall vest in full in the event of a
"change of control" or in the event that the closing price of the
Company's common stock reaches a minimum of $3.50 per share for 20
consecutive trading days. The options were valued utilizing the
Black-Scholes option pricing model resulting in an estimated fair
value of $55,000, which was charged to expense during the year ended
December 31, 2002. These options are treated as contingent options
and were originally priced in the quarter ended June 30, 2002 at
$416,000.

F-15

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)

[2] STOCK OPTIONS: (CONTINUED)

(c) Includes a five-year option to purchase 294,879 shares of common
stock at an exercise price of $2.42 per share issued outside the 1996
Plan which expired in May 2003. The option was issued in May 1998 in
connection with an employment agreement with the Company's former
President and Chief Executive Officer.

The option vested 34% immediately and then 22% per year thereafter.
As the estimated fair value of the Company's common stock at the date
of grant of the option ($5.60 per share) was in excess of the
exercise price, the Company incurred aggregate compensation expense
of approximately $938,000 over the service period, which has been
fully charged to expense as of June 2001. Expense pursuant to the
options was $26,000 in 2001. In June 2001, the President and Chief
Executive Officer resigned.

(d) On March 11, 2002, the Company entered into a two-year employment
agreement with Richard J. Kosinski, as Chief Executive Officer and
President, and issued to Mr. Kosinski ten-year options to purchase
1,200,000 shares of the Company's common stock at an exercise price
of $1.65 per share. The vesting schedule for these options was as
follows: (i) 25% of the shares (300,000 shares) on March 11, 2003 and
(ii) the balance of 75% of the shares over a three-year period in
equal amounts of 6.25% (75,000 shares) at the end of each three-month
period beginning March 11, 2003, subject to acceleration upon a
change of control of the Company. In July 2003, all the options
issued to Mr. Kosinski were forfeited in connection with the
settlement of a lawsuit by Mr. Kosinski against the Company (see Note
L[1]).

(e) The following table presents information relating to stock options
outstanding and exercisable at December 31, 2002:

WEIGHTED WEIGHTED
RANGE OF AVERAGE WEIGHTED AVERAGE AVERAGE
EXERCISE OPTIONS EXERCISE REMAINING OPTIONS EXERCISE
PRICES OUTSTANDING PRICE LIFE IN YEARS EXERCISABLE PRICE
--------------------- ----------- ----- ------------- ----------- -----

$ 0.13 - $ 2.91 2,504,924 $ 1.45 9.41 320,022 $ 1.49
$ 3.00 - $ 3.75 257,651 3.37 8.46 125,000 3.69
$ 4.13 - $ 5.69 146,200 5.40 8.04 122,280 5.36
$ 6.00 - $ 6.875 169,723 6.14 7.24 163,743 6.13
$10.00 - $ 10.125 76,000 10.11 8.37 57,120 10.10
----------- ---------

3,154,498 2.25 8.69 788,165 4.03
=========== =========

The weighted average fair value on the option grant date, including
the accelerated vesting of options for Professional Services Group
employees (Note G), during the years ended December 31, 2002 and 2001
were $1.13 and $1.53 per option, respectively.

F-16

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)

[3] WARRANTS:

As of December 31, 2002, the Company has the following outstanding
warrants to purchase shares of common stock:

NUMBER OF EXERCISE
WARRANTS PRICE EXPIRATION DATE
----------- ----- -----------------------------------
110,278 $1.00 December 22, 2004
62,080 1.61 October 11, 2003 - January 15, 2004
62,856 2.42 May 18, 2003 - April 4, 2004
100,104 6.44 March 14, 2006 - February 24, 2007
170,000 9.30 November 12, 2003
93,120 9.66 March 14, 2006
20,000 5.00 October 31, 2003 (a)
20,000 7.50 January 2, 2004 (a)
20,000 10.00 February 28, 2004 (a)
300,000 .70 July 11, 2011 (b)
250,000 1.48 October 8, 2006 (b)
1,352,048 1.11 December 22, 2004 (c)
500,000 1.27 October 2, 2006 (d)
6,372,642 1.27 October 2, 2004 (d)
66,621 2.03 April 13, 2006 (e)
64,352 2.00 July 2, 2006 (e)
4,489 2.10 October 1, 2006 (e)
-----------
9,568,590
===========

In November 2000, the Company entered into a business development
agreement with a marketing company and issued 200,000 warrants to purchase
the Company's common stock. The warrants expired in November 2002, had an
exercise price of $3.33, and had a cashless exercise provision. The
warrants would have vested as specified performance and revenue targets
are attained. Several of the performance targets were attained in 2001,
and accordingly, 12,000 warrants vested. Expense of $12,000 was recorded
based on the estimated fair value of the warrants when vested during the
year ended December 31, 2001. These warrants expired unexercised in
November 2002.

(a) Represents warrants issued pursuant to a consulting agreement with an
advisory firm. Under the agreement, entered into on October 31, 2000,
the Company was required to pay a monthly fee and issue 60,000
warrants. The warrants have exercise prices ranging from $5.00 to
$10.00, expire three years after issuance, and are issued 1/3 at the
inception of the agreement, 1/3 at 60 days, and 120 days after
inception. The warrants were valued at $82,000 using the
Black-Scholes option pricing model using the following weighted
average assumptions on the issuance dates: risk-free interest rate of
5.60, volatility of 113%, dividend yield of 0 and expected life of 3
years. The value of the warrants was charged to expense over the
six-month term of the agreement, resulting in $55,000 being charged
to expense in 2001.

F-17

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE F - STOCKHOLDERS' EQUITY (CONTINUED)

[3] WARRANTS: (CONTINUED)

(b) Issued to CMH Capital Management Corp. ("CMH") in 2001, a company
owned by the Chairman of the Board (see Note K[1]).

(c) Reflects adjustments required pursuant to anti-dilution provisions of
Series D preferred stock and notes payable offering (see Note F[1]).

(d) Issued with private offering of Series E preferred stock (see Note
F[1]).

(e) Issued to a software development company for services rendered. The
Company recognized an $80,000 expense related to the warrants based
on their estimated fair value using the Black-Scholes option pricing
model utilizing the following weighted average assumptions: risk free
rate of 4.5%, expected life of 3 years, volatility of 113%, and a
dividend yield of 0. The software development company has claimed
they are entitled to additional warrants for the services rendered
(see Note H[4]).

NOTE G - DISCONTINUED OPERATIONS

On February 9, 2000, the Company completed the sale of its Professional Services
Group ("PSG") to Exodus Communications, Inc. ("Exodus") for $4.0 million in
cash, of which $1.3 million was held in escrow subject to certain conditions.
Release to the Company of cash held in escrow was conditioned upon (i) as to
$1,000,000, certain PSG employees remaining employed by Exodus for at least one
year and (ii) as to $300,000, to the extent purchase orders or commitments are
secured by Exodus from certain customers within 90 days of the closing, up to a
maximum of $300,000. PSG provided consulting services in network security and
network design. Effective upon the sale, the Company granted options to acquire
104,063 shares of common stock at $2.91 per share and accelerated the vesting of
24,556 options that would have otherwise expired, with exercise prices ranging
from $1.50 to $6.50 to certain employees of PSG. In connection therewith, the
Company incurred a compensation charge of $794,000 based upon the intrinsic
value of the portion of the options vesting at such date. The balance of the
options vested one year after the closing provided that the employees were still
employed by Exodus. In addition, the Company agreed to pay bonuses aggregating
$160,000 to the former employees provided that they remained with Exodus for at
least one year. Charges relating to the contingent options and the remittance of
the bonuses are reflected as reductions of the gain on sale of discontinued
operations.

In the first quarter of 2000, Exodus secured $59,000 of purchase orders from the
designated customers and the Company recognized the related gain. In 2001, the
Company received the $1,000,000 from the escrow for the PSG employees remaining
employed by Exodus for one year, $115,000 as satisfaction of the remaining
$300,000 escrow, and $65,000 of interest on the two contingency payments. The
options vesting in February 2001 were valued at $230,000 using the Black-Scholes
option pricing model using the following assumptions on the date of vesting:
risk-free interest rate of 5.38%, volatility of 112.58%, dividend yield of 0 and
expected life of 6 years. In addition, the Company paid the $160,000 of bonuses
to the PSG employees and $17,000 of related payroll taxes. The completion of the
sale resulted in an additional net gain recognized in 2001 of $714,000 which was
reflected as a "gain on sale of discontinued operations" in the statements of
operations.

F018

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE H - COMMITMENTS AND CONTINGENCIES

[1] OPERATING LEASES:

At December 31, 2002, the Company leased an office facility in
Massachusetts which expired during February 2003. Rental commitment for
such facility at December 31, 2002 was approximately $32,000. During 2002,
the Company closed its New Hampshire and Shanghai, China office
facilities.

Rental expense for the years December 31, 2002 and 2001 aggregated
$376,000 and $319,000, respectively.

[2] SOFTWARE DISTRIBUTION AGREEMENTS:

(a) Pursuant to a software distribution agreement entitling the Company
to incorporate certain technology into its software, $100,000 of
royalties payable was accrued as of December 31, 2001 and has not
been paid as of December 31, 2002.

(b) Pursuant to an agreement under which certain technology was developed
for the Company, royalty payments of up to $100,000 may be payable.
As of December 31, 2002, royalties owed pursuant to such agreement
were not significant.

[3] SAVINGS AND INVESTMENT PLAN:

The Company has a Savings and Investment Plan which allows participants to
make contributions by salary reduction pursuant to Section 401(k) of the
Internal Revenue Code of 1986. The Company also may make discretionary
annual matching contributions in amounts determined by the Board of
Directors, subject to statutory limits. The Company did not make any
contributions to the 401(k) Plan during the years ended December 31, 2002
and 2001.

[4] SOFTWARE DEVELOPMENT CONTRACT DISPUTE:

The Company has a dispute with a software development company pertaining
to the number of warrants the Company is required to issue for services
rendered. The software development company has claimed they are entitled
to approximately 325,000 additional warrants than the Company has included
in the warrants outstanding in Note F[3]. The Company has included in
accrued expenses any additional liability it reasonably expects to incur
regarding this matter.

NOTE I - INCOME TAXES

At December 31, 2002, the Company has available net operating loss carryforwards
to reduce future federal taxable income of approximately $29,969,000 for tax
reporting purposes, which expire from 2009 through 2022. Pursuant to the
provisions of the Internal Revenue Code, future utilization of these past losses
is subject to certain limitations based on changes in the ownership of the
Company's stock that have occurred.

F-19

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE I - INCOME TAXES (CONTINUED)

The principal components of the net deferred tax asset are as follows:

YEAR ENDED
DECEMBER 31,
------------------------------
2002 2001
------------ ------------

Deferred tax assets:
Net operating loss carryforwards $ 11,238,000 $ 9,205,000
Options and warrants not yet deducted, for tax purposes 659,000 715,000
Other 382,000 221,000
------------ ------------

12,279,000 10,141,000
Valuation allowance (12,279,000) (10,141,000)
------------ ------------

Net deferred tax assets $ 0 $ 0
============ ============

The Company has recorded a valuation allowance for the full amount of its
deferred tax assets as the likelihood of its future realization cannot be
presently determined. The valuation allowance was increased by $2,138,000 in
2002 and $2,274,000 in 2001.

The reconciliation between the taxes as shown and the amount that would be
computed by applying the statutory federal income tax rate to the loss before
income taxes is as follows:

YEAR ENDED
DECEMBER 31,
------------------------------
2002 2001
------------ ------------

Income tax benefit - statutory rate (34.0)% (34.0)%
State and local, net (3.5) (3.5)
Increase in valuation allowance on deferred tax assets 37.5 38.7
Other (1.2)
----------- -----------

0.0 % 0.0 %
=========== ===========

NOTE J - CONCENTRATIONS

[1] For the year ended December 31, 2002, one customer accounted for revenues
of approximately $122,000 (21%). This customer was a reseller located in
Singapore. For the year ended December 31, 2001, two customers accounted
for revenues of approximately $154,000 (15%) and $144,000 (14%). The
customer representing 14% of revenues was a reseller located in China.

[2] For the years ended December 31, 2002 and 2001, export revenues, which
were primarily to Asia, amounted to approximately $168,000 and $219,000,
respectively.

[3] The Company places its cash investments in high quality financial
institutions insured by the Federal Deposit Insurance Corporation
("FDIC"). At December 31, 2002, the Company maintained cash balances of
$1,959,485 in excess of FDIC limits.

F-20

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE K - RELATED PARTY TRANSACTIONS AND RELATIONSHIPS

[1] In June 2001, upon the resignation of the Company's Chief Executive
Officer, the Company entered into a six-month consulting agreement with
CMH, a company owned by the Chairman of the Board of the Company. Pursuant
to the agreement, the Company paid CMH $17,500 per month and issued a
warrant to purchase 300,000 shares of the Company's common stock at an
exercise price of $.70 per share, which was the market price of the common
stock on the date of issuance. In addition, CMH was reimbursed for $18,000
and $44,000 of expenses incurred during the years ended December 31, 2002
and 2001, respectively, including the allocable portion of rent for office
space in New York City. The warrants were valued utilizing the
Black-Scholes option pricing model, resulting in an estimated fair value
of $180,000, which was expensed. In addition, in October 2001, in
consideration of additional consulting and financial advisory services,
the Company issued to CMH an additional warrant to purchase 250,000 shares
of the common stock at an exercise price of $1.48 per share, which was the
market price of the Company's common stock on the date of issuance. The
warrants were valued utilizing the Black-Scholes option pricing model,
resulting in an estimated fair value of $256,000, which was expensed upon
grant. The weighted average assumptions used in the Black-Scholes
valuations were risk-free interest rate of 4.03%, volatility of 114%,
expected life of 4.6 years and 0 dividend yield. In January 2002, the
agreement was extended to the lesser of six months or three months after
the date of hire of a new Chief Executive Officer. In July 2002, the
agreement was further extended until December 31, 2002. Since January
2003, the Company has continued its consulting arrangement with CMH on a
month-to-month basis.

[2] Investors in the 2001 Financing completed on October 2, 2001 (see Note
F[1](b)) included Falconstor ($2,650,000, including $350,000 allocated
from the Advance as the purchase price of the additional warrant they
received), Barry Rubenstein and affiliated entities ($1,750,000, including
$400,000 from Wheatley Partners II, L.P. and related entities), all
principal stockholders of the Company, and the wife ($75,000) of the
Chairman of the Board of Directors and a principal stockholder of the
Company.

[3] In December 2001, the Company entered into a one-year financial advisory
agreement with an investment banking firm, which required the Company to
pay $200,000 over the next ten months. At the time of entering into the
agreement, the firm's Chairman of the Board owned shares of Series E
preferred stock and an affiliate was the general partner of a partnership
that owned common stock and held convertible notes payable, subsequently
converted into common stock. During 2002, the Company agreed with the
investment banking firm that no further services would be needed and that
payments in the aggregate of $40,000 be considered as full satisfaction
under the agreement which was accrued at December 31 and paid in January
2003. The Company charged $153,000 and $17,000 to operations during the
years ended December 31, 2002 and 2001, respectively.

[4] As noted in F[1], the Company entered into a ten-year License and
Distribution Agreement with Falconstor, an investor in the 2001 Financing.
This agreement requires Falconstor to pay royalties after utilizing the
Advance as a credit. Deferred revenue at December 31, 2002 includes
$130,000 from this agreement, representing the unearned portion of the
$150,000 allocated from the Advance to the license fee, less accumulated
royalties earned of $20,000 through December 31, 2002. One of the
Company's principal stockholders is also a principal stockholder of
Falconstor, and an affiliated entity is the Series E designee noted in
F[1]. Also see Note L[4].

F-21

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001

NOTE L - SUBSEQUENT EVENTS

[1] In January 2003, the former Chief Executive Officer, President and a
director (the "Former CEO") of the Company commenced a lawsuit against the
Company for breach of his employment agreement for $200,000. In June 2003,
the Company entered into a settlement in which the Company agreed to pay
approximately $127,000 to the Former CEO in full settlement of all claims
asserted, which is reflected in the accompanying financial statements. In
addition, as part of the settlement, the Former CEO agreed to forfeit his
options to purchase 1,200,000 shares of the Company's common stock (see
Note F[2](d)).

[2] In January 2003, the former Chief Financial Officer and a director of the
Company commenced a lawsuit against the Company for breach of his
employment agreement for $190,000. Management believes that it has
meritorious defenses to the claims asserted. Accordingly, the Company has
not accrued any amount at December 31, 2002 that might result from such
litigation.

[3] In February 2003, the Company closed its principal offices in Waltham,
Massachusetts and moved its principal offices to a space in New York City
occupied by CMH. The Company continues to pay rent to CMH of $2,700 per
month, on a month-to-month basis.

[4] On May 30, 2003, the Company completed the sale of its "Assets" and
assignment of its rights under the Falconstor Agreement to the Purchaser
for aggregate proceeds of $415,000. (see Notes F[1](b) and K[4]).

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