10-Q

10-Q 1 v90132e10vq.htm 10-Q 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003


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

COMMISSION FILE NUMBER 0-26825

N2H2, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

WASHINGTON
(STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)

91-1686754
(I.R.S. EMPLOYER IDENTIFICATION NO.)

900 FOURTH AVENUE, SUITE 3600, SEATTLE, WA 98164
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (206) 336-1501

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes[ ] No[X]

As of May 8, 2003, the registrant had outstanding 22,131,253 shares of common stock, no par value.

TABLE OF CONTENTS


PART I—FINANCIAL INFORMATION
	ITEM 1. FINANCIAL STATEMENTS
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4. CONTROLS AND PROCEDURES
PART II—OTHER INFORMATION
	ITEM 1. LEGAL PROCEEDINGS
	ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
	ITEM 3. DEFAULTS UPON SENIOR SECURITIES
	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
	ITEM 5. OTHER INFORMATION
	ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
CERTIFICATIONS
EX-99.1

N2H2, INC.

TABLE OF CONTENTS


PART I—FINANCIAL INFORMATION			3
	Item 1. Financial Statements		3
		CONDENSED CONSOLIDATED BALANCE SHEETS	3
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS	4
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS	5
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	6
	Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations		9
	Item 3. Quantitative And Qualitative Disclosures About Market Risk		21
	Item 4. Controls and Procedures		21
PART II—OTHER INFORMATION			22
	Item 1. Legal Proceedings		22
	Item 2. Changes In Securities And Use Of Proceeds		22
	Item 3. Defaults Upon Senior Securities		22
	Item 4. Submission Of Matters To A Vote Of Security Holders		22
	Item 5. Other Information		22
	Item 6. Exhibits And Reports On Form 8-K		22
SIGNATURES			23
CERTIFICATIONS			24

PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

N2H2, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands)


				MARCH 31,			SEPTEMBER 30,
				2003			2002

ASSETS:
Current assets:
	Cash and cash equivalents			$	1,541		$	4,009
	Restricted cash and cash equivalents				675			675
	Investments				2,000			—

		Total cash and investments			4,216			4,684
	Accounts receivable, net of allowances				665			1,825
	Prepaid expenses and other current assets				360			737

		Total current assets			5,241			7,246
Property and equipment, net					766			1,249
Other assets, net					140			140

			Total assets	$	6,147		$	8,635

LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT):
Current liabilities:
	Accounts payable			$	204		$	262
	Accrued payroll & benefits				289			452
	Other accrued liabilities				437			467
	Deferred revenue				6,046			8,179
	Note payable				8			58
	Current portion of capital lease obligations				—			21

		Total current liabilities			6,984			9,439
Deferred revenue					967			863
Other non-current liabilities					81			105

		Total liabilities			8,032			10,407

Shareholders’ equity (deficit):
	Preferred stock, no par value; 50,000 shares authorized, no shares issued and outstanding				—			—
	Common stock, no par value; 250,000 shares authorized, 22,131 and 22,104 shares issued and outstanding, respectively				92,180			92,176
	Notes receivable from shareholders, net of allowances				(41	)		(41	)
	Deferred stock compensation				(3	)		(415	)
	Accumulated other comprehensive loss				(15	)		(102	)
	Accumulated deficit				(94,006	)		(93,390	)

		Total shareholders’ equity (deficit)			(1,885	)		(1,772	)

			Total liabilities and shareholders’ equity (deficit)	$	6,147		$	8,635

The accompanying notes are an integral part of these condensed consolidated financial statements.

N2H2, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands except per share amounts)


			THREE MONTHS ENDED						SIX MONTHS ENDED
			MARCH 31,						MARCH 31,

			2003			2002			2003			2002

Revenues:			$	3,097		$	2,672		$	6,124		$	5,565
Operating expenses:
	Internet filtering services and customer support			570			829			1,167			1,675
	Sales and marketing			1,271			1,861			2,683			3,660
	General and administrative			796			883			1,626			1,868
	Research and development			386			451			734			888
	Depreciation and amortization			202			510			478			1,044

				3,225			4,534			6,688			9,135
	Loss on disposal of property and equipment			10			68			22			69
	Loss on sale of N2H2 Pty Limited			61			—			61			—

		Total operating expenses		3,296			4,602			6,771			9,204

Loss from operations				(199	)		(1,930	)		(647	)		(3,639	)
Interest income, net of interest expense				12			26			31			70

Net loss			$	(187	)	$	(1,904	)	$	(616	)	$	(3,569	)

Foreign currency translation gain (loss)				3			—			38			24

Comprehensive loss			$	(184	)	$	(1,904	)	$	(578	)	$	(3,545	)

Basic and diluted net loss per share			$	(0.01	)	$	(0.09	)	$	(0.03	)	$	(0.16	)

Basic and diluted weighted average shares outstanding				22,005			21,798			21,969			21,761

The accompanying notes are an integral part of these condensed consolidated financial statements.

N2H2, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)


			SIX MONTHS
			ENDED MARCH 31,

			2003			2002

Cash flows from operating activities:
Net loss			$	(616	)	$	(3,569	)
Adjustments to reconcile net loss to net cash provided by (used by) operating activities:
		Depreciation and amortization		478			1,044
		Amortization of deferred stock compensation		413			1,119
		Change in accounting policy		(172	)		(540	)
		Loss on disposal of property and equipment		22			69
		Loss on sale of N2H2 Pty Limited		61			—
		Interest on shareholder loans		(10	)		(7	)
Changes in operating assets and liabilities:
		Accounts receivable		1,160			1,318
		Prepaid expenses and other current assets		377			344
		Other assets		(5	)		—
		Accounts payable		(58	)		(513	)
		Accrued liabilities		(193	)		(309	)
		Deferred revenue		(1,857	)		(1,120	)
		Other non-current liabilities		(24	)		—

Net cash used by operating activities:				(424	)		(2,164	)

Cash flows from investing activities:
		Maturities of investments		600			—
		Purchases of investments		(2,600	)		—
		Payments received on notes receivable from shareholders		9			—
		Additions to property and equipment		(25	)		(125	)
		Proceeds from sale of property and equipment		1			12

Net cash used by investing activities				(2,015	)		(113	)

Cash flows from financing activities:
		Issuance of common stock		4			6
		Exercise of stock options		—			1
		Payments under capital lease obligations		(21	)		(112	)
		Repayments of notes payable		(50	)		(36	)

Net cash used by financing activities				(67	)		(141	)

		Effects of exchange rate changes		38			24

Net decrease in cash				(2,468	)		(2,394	)
Cash, beginning of period				4,009			5,979

Cash, end of period			$	1,541		$	3,585

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
	Cash paid for interest		$	1		$	8

The accompanying notes are an integral part of these condensed consolidated financial statements.

N2H2, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

The accompanying condensed consolidated financial statements of N2H2, Inc. and subsidiaries (the Company) are unaudited. In the opinion of management, the financial statements include all adjustments, consisting only of normal recurring adjustments necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses and the disclosure of contingent assets and liabilities. Actual results may differ from these estimates. Operating results for the three and six-month periods ended March 31, 2003 are not necessarily indicative of results to be expected for a full year. The information included in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations herein, as well as with the financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended September 30, 2002 as filed with the Securities and Exchange Commission on December 19, 2002.

The Company has experienced net operating losses from inception and has an accumulated shareholders’ deficit. In fiscal 2002, the Company incurred operating losses of $6.6 million and used $1.8 million of cash in its operating activities. For the six-months ended March 31, 2003, the Company incurred operating losses of $616,000 and used $424,000 of cash in its operating activities. The Company anticipates that operating losses will continue through most or all of fiscal 2003 as the Company continues to develop its distribution channels and customer base. If cash generated from operations is insufficient to satisfy the Company’s longer-term liquidity requirements, the Company may seek to further reduce expenses, sell additional equity or debt securities, or obtain a credit facility to continue operations beyond twelve months from the date of this filing. Alternatively, management may seek to sell the Company. The incurring of indebtedness would result in increased fixed obligations and could result in covenants that would restrict the Company’s operations. The Company has not made arrangements to obtain additional financing and there can be no assurance that financing will be available in amounts or on acceptable terms, if at all.

Principles of Consolidation

The consolidated financial statements include the accounts of N2H2, Inc. and its wholly owned subsidiaries, N2H2, Ltd. and N2H2 Pty Limited. All inter-company accounts and transactions have been eliminated in consolidation. (Also see footnote 5.)

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.

Revenue Recognition

The Company’s revenues are derived primarily from sales of Internet filtering subscriptions. A smaller portion of its revenue also comes from installation and maintenance fees. The Company recognizes revenue in accordance with Statement of Position No. 97-2, Software Revenue Recognition (SOP 97-2). Accordingly, revenue is recognized when persuasive evidence of an arrangement exists, the product or service has been delivered, the fee is fixed and determinable, and collection is reasonably assured.

Subscription revenues represent the fees associated with the right to use the Company’s software and/or hardware, and to access the Company’s filtering updates. Maintenance revenues represent fees associated with technical support services provided to customers. Subscription and maintenance agreements are generally 12, 24 or 36 months in duration. Subscription and maintenance revenues are recognized on a straight-line basis over the life of the agreement. Amounts billed in advance of services provided are recorded as deferred revenue. The Company’s revenue growth is significantly influenced by subscription renewals, and a decrease in renewals could negatively impact the Company’s revenue.

Installation revenues represent one-time fees associated with the customization and installation of the Company’s software on customer servers. Installation services are billed upon completion and are recognized over the expected life of the customer relationship in accordance with Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements. The Company estimates the expected life of its customer relationships based on a number of factors, including customer type and customer history. Estimates of expected customer lives are assessed on an ongoing basis. A material change in the estimated customer life could significantly impact the rate at which the Company recognizes these revenues.

Reclassifications

Certain reclassifications of prior year balances have been made for consistent presentation with the current year. These reclassifications have not impacted previously reported net loss, shareholders’ equity or cash flows.

2. NET LOSS PER SHARE

Basic net loss per share is computed on the basis of the weighted average number of common shares outstanding. Diluted net loss per share includes common equivalent shares during the period, if dilutive. As the Company had a net loss attributable to common shareholders in each of the periods presented, basic and diluted net loss per share are the same.

The components of basic and diluted loss per share were as follows:


			THREE MONTHS						SIX MONTHS
			ENDED MARCH 31,						ENDED MARCH 31,

			2003			2002			2003			2002

			(in thousands, except per share data)
Numerator:
	Net loss		$	(187	)	$	(1,904	)	$	(616	)	$	(3,569	)
Denominator:
	Basic and diluted weighted average common shares outstanding			22,005			21,798			21,969			21,761

		Basic and diluted net loss per share	$	(0.01	)	$	(0.09	)	$	(0.03	)	$	(0.16	)

Warrants for 539,280 shares and options for 4,705,171 shares have been excluded from the calculation of diluted loss per share at March 31, 2003 because they are anti-dilutive. Warrants for 539,280 shares, options for 3,015,406 shares, and 170,596 restricted shares have been excluded from the calculation of diluted loss per share at March 31, 2002 because they are anti-dilutive.

3. CHANGE IN ACCOUNTING POLICY

In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (SAB 101). SAB 101 requires that up-front installation fees be deferred and recognized over the term of the customer relationship. In fiscal 2000 and previous years, the Company recognized installation revenue upon completion of the installation. Effective at the beginning of fiscal 2001, in accordance with the provisions of SAB 101, the Company began deferring installation revenue over the expected life of the customer relationship. The adoption of SAB 101 resulted in a one-time, non-cash charge of $3.6 million on October 1, 2000 for the cumulative effect of the change in accounting policy. The cumulative effect was recorded as deferred revenue and is being recognized as revenue over the remaining expected life of the customer relationship. The amount of related deferred revenue, which was recognized as revenue during the six-month periods ended March 31, 2003 and 2002 was $172,000 and $540,000, respectively. The remaining related deferred revenue of $57,000 will be recognized in the second half of fiscal 2003.

4. RESTRICTED CASH AND CASH EQUIVALENTS

The Company has $675,000 of restricted cash pledged as collateral for a letter of credit related to the Company’s leased office space in the amount of $665,000, expiring on July 31, 2005, and a $10,000 deposit held by Comerica for the issuance of corporate credit cards. The restriction will remain in effect through the term of these commitments. Alternatively, the Company may seek to obtain a line of credit to underwrite these obligations.

5. RELATED PARTY TRANSACTION

On February 23, 2003, the Company sold the assets and liabilities of its Australian subsidiary, N2H2 Pty Limited, for $31,000 to one of its directors who was the original owner of the entity. N2H2 Pty Limited functioned as a sales office in Queensland, Australia for N2H2’s Internet filtering and monitoring solutions. Simultaneous with the sale, the Company entered into a non-exclusive distribution agreement with the purchaser. Under the distribution agreement, the purchaser will continue to sell, distribute and support N2H2’s software and subscriptions to customers within Australia and New Zealand. The Company recorded a loss on the sale of $61,000.

6. STOCK-BASED COMPENSATION

The Company accounts for employee stock-based compensation under the provisions of Accounting Principles Board Opinion No. 25 (APB 25) and related interpretations. Statement of Financial Accounting Standards No. 123 (SFAS 123) permits the use of either a fair-value based method or the intrinsic value method under APB No. 25 to account for employee stock-based compensation arrangements. Companies that elect to use the intrinsic value method provided in APB No. 25 are required to disclose the pro forma net income (loss) and net income (loss) per share that would have resulted from the use of the fair value method. The Company has provided below the pro forma disclosures of the effect on net income (loss) and net income (loss) per share as if SFAS No. 123, as amended by SFAS No. 148, had been applied in measuring compensation expense for all periods presented.


		THREE MONTHS						SIX MONTHS
		ENDED MARCH 31,						ENDED MARCH 31,

		2003			2002			2003			2002

		(in thousands,						(in thousands,
		except per share data)						except per share data)
Net income, as reported		$	(187	)	$	(1,904	)	$	(616	)	$	(3,569	)
Add: Stock-based employee compensation expense included in reported net loss, net of related tax effects			—			3			—			6
Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects			(25	)		(198	)		(189	)		1,323

Pro forma net loss		$	(212	)	$	(2,099	)	$	(805	)	$	(2,240	)

Earnings per share:
	Basic and diluted net loss per share, as reported	$	(0.01	)	$	(0.09	)	$	(0.03	)	$	(0.16	)

	Basic and diluted net loss per share, pro forma	$	(0.01	)	$	(0.10	)	$	(0.04	)	$	(0.10	)

7. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In December 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation - Transition and Disclosure. SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based compensation. It also amends the disclosure provisions of that statement. The disclosure provisions of SFAS 148 are effective for financial statements issued for fiscal periods beginning after December 15, 2002 and will become effective for the Company commencing with the second quarter of the 2003 fiscal year. The Company does not currently have plans to change to the fair value method of accounting for its stock-based compensation.

In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. This interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, addresses consolidation by business enterprises of variable interest entities. FIN 46 defines the concept of “variable interests” and requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among the parties involved. This interpretation applies immediately to variable interest entities created after January 31, 2003. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The Company is in the process of assessing the impact of the adoption of FIN 46 but does not expect that the adoption will have a material impact on its financial statements.

In January 2003, the Emerging Issues Task Force issued EITF Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. This consensus addresses certain aspects of accounting by a vendor of arrangements under which it will perform multiple revenue-generating activities, specifically, how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. EITF Issue No. 00-21 is effective for revenue arrangements entered into in fiscal periods

beginning after June 15, 2003 or entities may elect to report the change in accounting as a cumulative-effect adjustment in accordance with APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, with early application of this consensus permitted. Since all of the Company’s deliverables are within the scope of other existing higher-level authoritative literature, the adoption of EITF Issue No. 00-21 will not impact the Company’s consolidated financial statements.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

FORWARD LOOKING INFORMATION

Our disclosure and analysis in this report contain forward-looking statements, which provide our current expectations or forecasts of future events. Forward-looking statements in this report include, without limitation:

• statements about our future capital requirements, our future cash flows and the sufficiency of our existing cash, cash equivalents, investments and available bank borrowings to meet these requirements;

• information concerning possible or assumed future results of operations, trends in financial results and business plans, including those relating to earnings growth and revenue growth;

• statements about the level of our costs and operating expenses relative to our revenues;

• other statements about our plans, objectives, expectations and intentions; and

• other statements that are not historical facts.

Words such as “believes,” “anticipates” and “intends” may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking. Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the factors described in the section entitled “Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price” in this report. Other factors besides those described in this report could also affect actual results. You should carefully consider the factors described in the section entitled “Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price” in evaluating our forward-looking statements.

You should not unduly rely on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to publicly revise any forward-looking statement to reflect circumstances or events after the date of this report, or to reflect the occurrence of unanticipated events. You should, however, review the factors and risks we describe in the reports we file from time to time with the Securities and Exchange Commission, or SEC.

OVERVIEW

N2H2 is an international Internet monitoring and filtering company. Our solutions help customers control, manage and understand their Internet use by filtering Web content, monitoring Internet access and delivering concise reports on user activity. These safeguards are designed to enable organizations of any size to mitigate potential legal liability, increase user productivity and optimize network bandwidth.

Our Bess® and Sentian™ filtering solutions are powered by our premium-quality filtering database - a list recognized by independent and respected third-parties as the most effective in the industry. N2H2 is based in Seattle, Washington and serves millions of users worldwide. Our software solutions are Cisco Verified, Microsoft Gold Certified and Check Point OPSEC compliant and are available for major platforms and devices.

As a leading provider of Internet content filtering to schools, we are attempting to leverage our expertise in filtering large-scale networks within sensitive environments via additional channel presence and expansion plans for corporations, governments, and other organizations. We have customers in several countries including Australia, Canada, Chile, the Dominican Republic, Japan, Mexico, the United Kingdom and the United States. To cover these markets, we use a combination of our own sales force and various resellers, both domestic and international.

Our prospects are subject to the risks, expenses, and difficulties encountered by companies in the rapidly evolving Internet market. As of March 31, 2003, we had incurred aggregate operating losses of approximately $94.0 million from inception. These losses have been funded primarily through the issuance of common stock. We intend to continue to seek opportunities to grow revenue and improve efficiencies in our operations to reduce operating losses.

RESULTS OF OPERATIONS – THREE MONTHS ENDED MARCH 31, 2003

Revenue

We generate our revenue primarily from subscriptions for our Internet filtering, monitoring, and reporting services. A smaller portion of our revenue also comes from installation and maintenance fees.

Revenue increased by 16% to $3.1 million for the quarter, compared to $2.7 million for the comparable period in the prior fiscal year. Revenue increased due to the addition of new customers, primarily in the corporate and education markets. Our growing network of resellers continues to build momentum and contribute to our increased revenue. The increase in revenue was partially offset by a decline in revenue recognized in conjunction with the adoption of SAB 101. The amount of related SAB 101 revenue recognized during the quarter was $77,000, down from $196,000 in the same quarter of the prior year. Excluding these amounts, revenue from customers increased 22% over the same quarter of the prior year.

Internet filtering services and customer support costs

Internet filtering services and customer support costs consist of the costs of Website review, technical installation and support, costs associated with building and maintaining our database, collocation, bandwidth, and an allocation of corporate facilities costs.

Internet filtering services and customer support costs decreased by 31% to $570,000 for the quarter, compared to $829,000 for the comparable period in the prior fiscal year. The decrease is primarily due to reductions in employee count that took place in the fourth quarter of fiscal 2002. We anticipate that Internet filtering services and customer support costs will remain materially consistent with current levels through the remainder of the fiscal year.

Sales and marketing

Sales and marketing expenses consist primarily of salaries, commissions and stock compensation expense for personnel engaged in selling and marketing functions, and various marketing programs, such as public relations, advertising, and lead generation. Sales and marketing also includes an allocation of corporate facilities costs.

Sales and marketing expenses decreased by 32% to $1.3 million for the quarter, from $1.9 million for the comparable period in the prior fiscal year. The decrease is primarily due to reduced deferred stock compensation expense. Deferred stock compensation was amortized using an accelerated method, which resulted in higher expense in fiscal 2002 as compared to 2003. Deferred stock compensation became fully amortized during the quarter, thus eliminating this expense for future periods. The decrease is also due in part to reductions in the employee count that took place in the fourth quarter of fiscal 2002. We anticipate that overall sales and marketing expenses will decline slightly in the remainder of fiscal 2003, primarily due to the elimination of deferred stock compensation expense, partially offset by increased spending on marketing programs.

General and administrative

General and administrative expenses consist primarily of salaries, benefits and related costs for executive, finance, human resources and administrative personnel, third party professional service fees, insurance costs, and an allocation of corporate facilities costs.

General and administrative expenses decreased by 10% to $796,000 for the quarter, from $883,000 for the comparable period in the prior fiscal year. This decrease is due in part to reductions in administrative staffing that took place in the fourth quarter of fiscal 2002. We also realized cost savings on Internet connectivity and collocation fees by changing vendors and negotiating more favorable terms in fiscal 2002. We anticipate that general and administrative expenses will increase in future quarters as a result of increasing expenses associated with being a public company.

Research and development

Research and development costs consist primarily of salaries and benefits for software developers, consulting fees and an allocation of corporate facilities costs. Research and development activities consist primarily of developing new filtering products and enhancing existing products. Product costs related to internal research and development have been expensed as incurred.

Research and development expenses decreased by 14% to $386,000 for the quarter, from $451,000 for the comparable period in the prior fiscal year. This decrease is due primarily to reductions in employee count that took place in the fourth quarter of fiscal 2002, and our reduced usage of contractors and third party service providers in the development of our products. We anticipate that research and development costs will remain materially consistent with current levels through the remainder of the fiscal year.

Depreciation and amortization

Depreciation and amortization expenses decreased by 60% to $202,000 for the quarter, from $510,000 for the comparable period in the prior fiscal year. This decrease is due to certain of our fixed assets and leasehold improvements becoming fully depreciated.

Loss on disposal of property and equipment

We incurred a $10,000 loss on disposal of property and equipment resulting from the abandonment of certain servers that we are no longer using in our operations.

Loss on sale of N2H2 Pty Limited

On February 23, 2003, we sold the assets and liabilities of our Australian subsidiary, N2H2 Pty Limited, for $31,000 to one of its directors who was the original owner of the entity. N2H2 Pty Limited functioned as a sales office in Queensland, Australia for N2H2’s Internet filtering and monitoring solutions. Simultaneous with the sale, we entered into a non-exclusive distribution agreement with the purchaser. Under the distribution agreement, the purchaser will continue to sell, distribute and support N2H2’s software and subscriptions to customers within Australia and New Zealand. We recorded a loss on the sale of $61,000.

Interest income and expense

Interest income consists primarily of interest earned on our cash equivalents and short-term investments. Interest expense consists of interest paid on our note payable and in the prior year, our capital lease obligations. Net interest income decreased by 54% to $12,000, from $26,000 for the comparable period in the prior fiscal year. The decrease is due to our reduced combined cash and investment balances.

RESULTS OF OPERATIONS – SIX MONTHS ENDED MARCH 31, 2003

Revenue

Revenue increased by 10% to $6.1 million for the six-month period, compared to $5.6 million for the comparable period in the prior fiscal year. Revenue increased due to the addition of new customers, primarily in the corporate and education markets. Our growing network of resellers continues to build momentum and contribute to our increased revenue, and our Bess and Sentian filtering solutions continue to make up the majority of our sales, with these subscriptions accounting for 66% of our sales during the period. The increase in revenue was partially offset by a decline in revenue recognized in conjunction with the adoption of SAB 101. The amount of related SAB 101 revenue recognized during the period was $172,000, down from $540,000 in the same period of the prior year. Excluding these amounts, revenue from customers increased 18% over the same quarter of the prior year.

Internet filtering services and customer support costs

Internet filtering services and customer support costs decreased by 30% to $1.2 million for the six-month period, compared to $1.7 million for the comparable period in the prior fiscal year. The decrease is primarily due to reductions in employee count that took place in the fourth quarter of fiscal 2002, and Internet connectivity and collocation cost savings realized by changing vendors and negotiating more favorable terms in fiscal 2002.

Sales and marketing

Sales and marketing expenses decreased by 27% to $2.7 million for the six-month period, from $3.7 million for the comparable period in the prior fiscal year. The decrease is primarily due to reduced deferred stock compensation expense. Deferred stock compensation was being amortized using an accelerated method, which resulted in higher expense in fiscal 2002 as compared to 2003. Deferred stock compensation became fully amortized during the period, thus eliminating this expense for future periods. The decrease is also due in part to reductions in the employee count that took place in the fourth quarter of fiscal 2002. The decrease in sales and marketing expense was partially offset by increased spending on various marketing programs, as we continue to build, train and support our distribution channels.

General and administrative

General and administrative expenses decreased by 13% to $1.6 million for the six-month period, from $1.9 million for the comparable period in the prior fiscal year. This decrease is due in part to reductions in administrative staffing that took place in the fourth quarter of fiscal 2002. We also realized cost savings on Internet connectivity and collocation fees by changing vendors and negotiating more favorable terms in fiscal 2002, and we incurred less bad debt expense as the improved financial stability of our customer base resulted in an improved collection rate.

Research and development

Research and development expenses decreased by 17% to $734,000 for the six-month period, from $888,000 for the comparable period in the prior fiscal year. This decrease is due in part to reductions in employee count that took place in the fourth quarter of fiscal 2002, and our reduced usage of contractors and third party service providers in the development of our products.

Depreciation and amortization

Depreciation and amortization expenses decreased by 54% to $478,000 for the six-month period, from $1.0 million for the comparable period in the prior fiscal year. This decrease is due to certain of our fixed assets and leasehold improvements becoming fully depreciated.

Interest income and expense

Net interest income decreased by 56% to $31,000, from $70,000 for the comparable period in the prior fiscal year. The decrease is due to our reduced combined cash and investment balances.

LIQUIDITY AND CAPITAL RESOURCES

As of March 31, 2003, we had $4.2 million in cash and investments, which consisted of cash and cash equivalents of $2.2 million (including restricted cash of $675,000) and short term investments of $2.0 million, compared to $4.68 million (including restricted cash of $675,000) at September 30, 2002. The decrease in cash and cash equivalents is primarily due to cash used to fund operations, combined with minor purchases of computer equipment and payments under capital lease and note payable obligations. Operating activities consumed $424,000 for the six-month period, compared to $2.2 million for the comparable period in the prior fiscal year.

Investing activities consumed $2.0 million for the six-month period, compared to $113,000 for the comparable period of the prior fiscal year. Investing activities consist primarily of purchases of short-term investments, combined with minor purchases of computer equipment, partially offset by amounts collected on notes receivable. The additions to property and equipment during the period consist of computers purchased to support internal operations. We anticipate a small increase in equipment purchases in future quarters to support our internal operations and our growing customer base.

Financing activities consumed $67,000 for the six-month period, compared to $141,000 for the comparable period of the prior fiscal year. Financing activities consist of payments under capital lease and note payable obligations, partially offset by proceeds from the issuance of common stock under our employee stock purchase plan. Restricted cash of $675,000 is pledged as collateral for a letter of credit related to our leased office space in the amount of $665,000, expiring on July 31, 2005, and a $10,000 deposit held by Comerica for the issuance of corporate credit cards. The restriction will remain in effect through the term of these commitments. Alternatively, we may seek to obtain a line of credit to underwrite these obligations.

We have experienced significant net operating losses from inception. In fiscal 2002, we incurred operating losses of $6.6 million and used $1.8 million of cash in our operating activities. For the six-months ended March 31, 2003, we incurred operating losses of

$616,000 and used $424,000 of cash in our operating activities. We anticipate that operating losses will continue through most or all of fiscal 2003 as we continue to develop our distribution channels and customer base. Given our reduced level of employees and operating expenses, and our customer renewal rates, we believe that our cash on hand, together with cash generated from operations, will be sufficient to meet our anticipated cash needs for at least the next twelve months. If cash generated from operations is insufficient to satisfy our longer-term liquidity requirements, we may seek to further reduce expenses, sell additional equity or debt securities, obtain a credit facility, or sell N2H2. The incurring of indebtedness would result in increased fixed obligations and could result in covenants that would restrict our operations. We have not made arrangements to obtain additional financing and we cannot assure you that financing will be available in amounts or on terms acceptable to us, if at all. If revenues generated from operations are insufficient to satisfy our long-term liquidity requirements and we are not successful in further reducing expenses, raising additional funds, or finding a buyer for N2H2 on acceptable terms when needed, our business would not succeed.

Following is a summary of our significant unconditional contractual obligations and commercial commitments:


		Payments Due by Period

				Less than						After
		Total		1 year		1-3 years		4-5 years		5 years

Contractual Obligations:
	Operating Lease	$	3,090,000	$	1,247,000	$	1,843,000		—		—

The above contractual lease obligations will be partially offset by sublease proceeds in the amount of $473,000 to be received ratably over the term of the lease.

IMPORTANT FACTORS THAT MAY AFFECT OUR BUSINESS, OUR RESULTS OF OPERATIONS AND OUR STOCK PRICE

If we are unable to achieve profitability as planned, we may need additional funding to continue operations. We may be unable to obtain additional funding and any funding we do obtain could dilute our shareholders’ ownership interest in N2H2.

Our future revenues may be insufficient to support the expenses of our operations and the expansion of our business. We may therefore need to raise additional capital to finance our operations. If we are unable to raise additional capital on acceptable terms, we may seek to further reduce expenses, obtain a credit facility, or sell N2H2. The incurring of indebtedness would result in increased fixed obligations and could result in covenants that would restrict our operations. If revenues generated from operations are insufficient to satisfy our long-term liquidity requirements and we are not successful in further reducing expenses, raising additional funds, or finding a buyer for N2H2 on acceptable terms when needed, our business would not succeed.

We believe that our existing cash and cash equivalents will be sufficient to meet our capital requirements for at least the next 12 months. However, we may seek additional funds before that time through public or private equity financing or from other sources to fund our operations and pursue our business strategy. We have no commitment for additional financing, and we may experience difficulty in obtaining additional financing on favorable terms, if at all. The delisting of our common stock from the Nasdaq National Market, and commencement of trading on the OTC-BB may also make it even more difficult for us to obtain financing. Further, if we issue additional equity securities, shareholders may experience significant dilution, and the new equity securities may have rights, preferences or privileges senior to those of existing holders of our common stock.

We have a history of losses and may not achieve profitability, which could force us to reduce or cease operations.

We have incurred net losses in each quarter since we incorporated in 1995. We incurred net losses of $881,000 for 1997, $2.6 million for 1998, $7.7 million for 1999, $39.3 million for 2000, $35.5 million for 2001, $6.6 million for 2002 and $616,000 for the six-months ended March 31, 2003. If we fail to achieve and maintain profitability, our stock price will decline, our future capital raising efforts will be impaired and we may be forced to reduce or cease operations.

Our restructuring initiatives in the fourth quarter of fiscal 2002 have reduced our costs and operating expenses. However, despite these initiatives, our operating expenses will continue to consume a significant amount of our cash resources in the near term. In addition, the restructuring may adversely affect our business and operating results. As a result, we will need to increase our revenues in order to achieve profitability. Although our revenues have grown in recent quarters, we may not be able to continue this growth to achieve or maintain profitability. Our continued losses and financial condition may cause some of our potential customers to question our viability, which may hamper our ability to sell our products.

Our common stock is traded on the Over-the-Counter Bulletin Board and, as a result, it may be less liquid and subject to greater price fluctuations.

On March 20, 2002, we received notification from the Nasdaq National Market that N2H2 had failed to meet Nasdaq listing requirements as set forth in Marketplace Rule 4450(a)(3). Our common stock was delisted from Nasdaq effective after the close of trading on March 20, 2002. Effective with the opening of business on March 21, 2002, our common stock began trading on the Over-The-Counter Bulletin Board, or OTC-BB, under the symbol “NTWO”. The OTC-BB is not an exchange, and trading in stocks on the OTC-BB is often more sporadic and lower in volume than that in shares on the national exchanges. We cannot guarantee that our shares will ever be listed on the Nasdaq National Market, or any other national stock exchange, in the future. As a result, it may be more difficult to dispose of, or to obtain adequate quotations, as to the price of our common stock.

You may be unable to resell your shares at or above the price at which you purchased them, and our stock price may be volatile.

Stocks trading on the OTC-BB are often subject to price fluctuations that are unrelated, or disproportional, to the operating performance of the companies. The price of our common stock has historically been volatile, even before it was delisted from Nasdaq, since our initial public offering in August 1999. Our common stock reached a high of $33.13 per share on December 14, 1999 and traded as low as $0.11 per share on various occasions, most recently on April 10, 2003. As a result of fluctuations in the price of our common stock, you may be unable to sell your shares at or above the price at which you purchased them. The trading price of our common stock could be subject to fluctuations for a number of reasons, including

• actual or anticipated quarterly variations in operating results;

• announcements of technological innovations or new services or products by us or our competitors;

• changes in analysts’ earning projections or recommendations;

• our failure to meet or exceed analyst estimates;

• announcements of technological innovations;

• the introduction of new products;

• proprietary rights litigation or other litigation; and

• other events or factors, many of which are beyond our control.

In addition, stock prices for many technology companies fluctuate widely for reasons that may be unrelated to operating results of these companies. These fluctuations, as well as general economic, market and political conditions, such as national or international currency and stock market volatility, recessions or military conflicts, may materially and adversely affect the market price of our common stock, regardless of our operating performance and may expose us to class action securities litigation which, even if unsuccessful, would be costly to defend and distracting to management.

We may be subject to third-party claims resulting from termination of our advertising contracts.

During 2001, we terminated the advertising-based revenue model that we had previously offered to schools. In connection with the termination of our advertising based-revenue model, we have unilaterally terminated certain advertising contracts. These advertising contracts may not allow unilateral termination by us. As a result, we may be subject to liabilities associated with breach of contract claims, although we have not received notice of any such claims. Even if none of these claims is successful, the litigation could result in substantial costs to the company and divert management’s time and attention away from business operations.

Economic conditions could adversely affect our revenue growth and ability to forecast revenue.

Our revenue growth and potential for profitability depend on the overall demand for filtering and monitoring products, which is impacted by general economic and business conditions. A softening of demand for computer software caused by the weakened

economy, both domestic and international, has affected our sales and may continue to result in decreased revenues and growth rates. As a result of the economic downturn, we may also experience difficulties in collecting outstanding accounts receivable from our customers. In addition, the terrorist attacks on the United States in 2001, the armed conflicts that have followed, and the threat of additional future armed conflicts, have added or exacerbated economic, political and other uncertainties, which could adversely affect our sales and thus our revenue growth. The slowdown in the domestic and international economies, as well as the effects of terrorist activity and armed conflict, may continue to cause customers and potential customers to delay their decisions about purchasing our filtering solutions, to reduce the amount they purchase or to cancel their orders, which could adversely affect our business and operating results.

Our quarterly financial results fluctuate and could fall below expectations of securities analysts and investors, resulting in a decrease in our stock price.

Our quarterly operating results have fluctuated significantly in the past and are likely continue to fluctuate in the future. If our operating results fall below the expectations of securities analysts and investors, it could result in a decrease in our stock price. Operating results vary from quarter to quarter, depending on a number of factors, many of which are outside our control, including:

• general economic conditions, which may affect our customers’ investment levels in enterprise software;

• the rate of market acceptance of new product introductions;

• budget and spending decisions by our customers;

• subscription renewal rates of our existing customers;

• our ability to compete in the highly competitive Internet filtering solutions market;

• the loss of any key technical, sales, customer support or management personnel and the timing of any new hires;

• our ability to develop, introduce and market new products and product versions on a timely basis;

• our ability to successfully expand our operations, and the amount and timing of expenditures related to this expansion;

• the tendency of our educational customers to budget and make purchases on the basis of a fiscal school year beginning in the fourth fiscal quarter of each year; and

• the length of our sales cycle, which varies substantially from customer to customer.

As a result of all these factors, we cannot predict our revenues with any significant degree of certainty, and future product revenues may differ from historical patterns. Even though our revenues are difficult to predict, we base our decisions regarding our operating expenses on anticipated revenue trends. Many of our expenses are relatively fixed, and we cannot quickly reduce spending if our resources are lower than expected. As a result, revenue shortfalls could result in significantly lower income or greater loss than anticipated for any given period, which could result in a decrease in our stock price.

If potential customers do not accept our Internet and monitoring filtering solutions, our business will not succeed.

We currently expect the substantial majority of our future revenues to be generated through sales of our Bess and Sentian Internet filtering and monitoring solutions. As a result, factors adversely affecting the pricing or demand for Internet filtering solutions, such as competition or technological change, could dramatically affect our operating results. In addition, many of our Bess and Sentian solutions were only recently introduced in fiscal 2002. As a result, they are relatively new and unproven and may not achieve market acceptance. Because these solutions are relatively new, we cannot accurately predict the rate at which customers will renew their annual subscriptions.

Our future financial performance will depend, in part, upon the successful development, introduction, and customer acceptance of new and enhanced versions of our Internet filtering and monitoring products and services. We cannot be certain that we will be

successful in upgrading and continuing to sell our Internet filtering products and services, or that any new products or services that we may develop or acquire, will achieve market acceptance. If we are unable to upgrade our services or products or to establish market acceptance of these products, our business will not succeed.

If existing customers do not renew their subscription agreements, our business will not succeed.

Our future success depends on the rate at which our existing customers renew their subscription contracts. Our customers have no obligation to renew their subscriptions upon expiration. Because our Bess and Sentian solutions are relatively new, we cannot predict with certainty the rate at which our customers will renew their annual subscriptions. We may be unable to generate significant revenue from our renewals and, as a result, our operating results could fall below the expectations of analysts and investors, which could cause our stock price to decline.

If our solutions fail to correctly categorize all potentially objectionable content, public perception of our products and services could be harmed.

We will not succeed unless the marketplace is confident that our solutions effectively filter Internet content. We rely upon a combination of automated filtering technology and human review to categorize Web site content for use by our filtering solutions. The total number of Web sites and partial Web sites is growing rapidly. We cannot be sure that our filtering technologies will successfully categorize all potentially objectionable Internet content for our clients, thus causing over-blocking. Our categorized database also may not contain substantially all of the material available on the Internet fitting into any one of our content categories. In addition, our customers may not agree with our categorization determinations. Our failure to effectively categorize and filter Internet content according to our customers’ expectations could result in lost customers and generate negative publicity that would impair the growth of our business and our efforts to increase positive associations with our brand.

Free speech and privacy concerns could adversely affect the demand for our Internet filtering solutions.

There has been a public-policy debate regarding Internet filtering in schools and libraries within the U.S. Congress. This debate has resulted in the CIPA, a law mandating Internet filtering in schools and libraries receiving certain federal funds, among other requirements. A United States District Court, however, has declared this act as it applies to public libraries unconstitutional. This decision has been appealed to the United States Supreme Court, which has accepted the case and is expected to rule by June 2003. If CIPA is ultimately held unconstitutional, some of our current customers may decide to no longer provide filtering in their organizations. This in turn would lead them to not renew contracts with us and would thereby harm an important source of our revenues. If the Supreme Court determines that filtering by public libraries is unconstitutional, plaintiffs and advocacy groups may rely on this decision to challenge the constitutionality on First Amendment grounds of mandatory filtering in public schools. Because public school customers still represent the majority of our revenue, an ultimate finding by the Supreme Court that mandatory filtering in public schools is unconstitutional could have a serious adverse effect on our future revenues.

We have been named as a defendant in an action by the American Civil Liberties Union that could weaken our intellectual property rights and result in substantial costs to the company.

In July 2002, an individual represented by the American Civil Liberties Union filed a lawsuit against us in federal court. The plaintiff is purportedly a computer researcher who allegedly seeks to conduct a quantitative analysis of the accuracy and comprehensiveness of our Internet filtering solutions for purposes of determining whether these solutions exclude some speech on the Internet that is constitutionally protected. He alleges that his activities in conducting this analysis, if he ever does so, would violate our standard license agreement and our intellectual property rights. The plaintiff alleges that the threat that we will enforce our license agreement and our other rights has deterred him from this activity, which he alleges is protected under the “fair use” doctrine of copyright law and other legal doctrines. He seeks a declaration to prohibit us from enforcing the license agreement against him based on his use of our software in his research activities. Our Motion to Dismiss this action has been granted, and judgment was entered in our favor on April 17, 2003. If the plaintiff decides to appeal, he has until no later than May 17, 2003 to do so. If Mr. Edelman does appeal, the litigation could result in substantial costs to the company and divert management’s time and attention away from business operations. If the appeal and the claim are ultimately resolved in the plaintiff’s favor, it could materially affect our ability to enforce our license agreements and other intellectual property rights against certain users of our software filtering products. In addition, it could contribute to an increase in the number of people who seek to use our software in ways that we believe violate our proprietary rights.

If we are unable to compete successfully in the Internet filtering market, our business will not succeed.

The market for our solutions is intensely competitive and rapidly changing. Many of our competitors are larger than we are and have substantially greater resources than we do. Our major competitors and their respective products are Surf Control – SuperScout and CyberPatrol, Websense – Websense Enterprise, Symantec – I-Gear and Secure Computing – SmartFilter. We also face competition from a number of smaller competitors.

In the future, we may face increased competition from vendors of Internet-related hardware and software that enhance their products or develop separate products that include functions that are currently provided in our products. If Internet filtering functions become standard features of Internet-related hardware or software, the demand for our products will decrease. Furthermore, even if our products offered greater functionality and are more effective than products offered by Internet-related hardware or software vendors, potential customers might accept this limited functionality instead of purchasing our products.

Some of our competitors’ filtering products are significantly less expensive than ours. This lower cost, along with other factors, may lead to greater market acceptance of our competitors’ products and services than for ours. Increased competition or our failure to compete effectively could force us to reduce our prices or the quality of our offerings. It could also reduce our market share and impact the profitability of our business. In addition, many of our competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, marketing and other resources than we do. Furthermore, a number of our competitors have recently been acquired by other large technology companies, which enhances their resources. We believe that there will be further consolidation among our competitors. As a result, they may be able to adapt more quickly to new technologies and customer needs, devote greater resources to promoting or selling their products and services, initiate and withstand substantial price competition, take advantage of acquisition or other strategic opportunities more readily or develop and expand their product and service offerings more quickly than we can. In addition, our competitors may form strategic relationships with each other and with other companies in attempts to compete more successfully against us. These relationships may take the form of strategic investments, joint marketing agreements, licenses or other contractual arrangements, any of which may increase our competitors’ ability, relative to ours, to address customer needs with their software and service offerings and that may enable them to rapidly increase their market share.

If we are unable to develop and maintain effective long-term relationships with key resellers, or if our resellers fail to perform, our ability to sell our solutions will be limited.

During 2001, we significantly reduced our direct sales staff and began to develop our reseller channel for selling products and services to corporations and government entities. In order to establish market share in these markets and increase revenue, we will need to substantially increase the distribution of our products and services through successful new relationships with prestigious resellers. Because our relationships with our existing resellers are relatively new and unproven, we cannot predict the degree to which these resellers will succeed in marketing and selling our solutions. Many of our existing and potential resellers have similar, and often more established, relationships with our competitors. These existing and potential resellers, many of whom have significantly greater resources than we have, may in the future market products that compete with our solutions or reduce or discontinue their relationships with us or their support of our solution. In addition, our sales and revenue growth opportunities will be limited if

• we are unable to develop and maintain effective, long-term relationships with existing and potential key resellers;

• our existing and potential key resellers endorse products or technologies other than our solutions; or

• our existing and potential key resellers do not have or do not devote the resources necessary to effectively sell our solutions.

If we do not retain our key employees and management team, our ability to execute our business strategy will be limited.

Our future performance will depend largely on the efforts of our key technical, sales, customer support and managerial personnel and on our ability to attract and retain them. In addition, our ability to execute our business strategy will depend on our ability to recruit additional experienced management personnel and to retain our existing executive officers. Our key employees are not obligated to continue their employment with us and could leave at any time. If we are unable to attract and retain these key employees and executive officers, our growth could be limited due to our lack of capacity to provide our services. We could also experience deterioration in service levels or decreased customer satisfaction.

Competition for qualified personnel in the software and technology markets is particularly intense. Many of the companies we compete against for experienced personnel have greater resources than we do. In addition, due to the trading prices of our common stock and our delisting from the Nasdaq National Market, our employees may perceive our equity incentives such as stock options as less attractive. In that case, our ability to attract or retain employees may be adversely affected and we may be required to increase the level of cash compensation paid to existing and new employees, which could materially increase our operating expenses.

Our workforce reduction and financial performance may place additional strain on our resources and may harm the morale and performance of our personnel and our ability to hire new personnel.

During September of 2002, we reduced our employee count by about 25%. Our restructuring plan may yield unanticipated consequences, such as attrition beyond our planned reduction in force. Although we believe we can operate at current staffing levels, this workforce reduction has placed significant strain on our administrative, operational and financial resources and has resulted in increased responsibilities for each of our management personnel. As a result, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. In addition, many of the employees who were terminated possessed specific knowledge or expertise, and that knowledge or expertise may prove to have been important to our operations. In that case, their absence may create significant difficulties. Further, the reduction in workforce may reduce employee morale and create concern among potential and existing employees about job security at N2H2, which may lead to difficulty in hiring and increased turnover in our current workforce. In addition, this reduction to employee count may subject us to the risk of litigation, which could result in substantial costs to N2H2 and could divert management’s time and attention away from business operations.

If we do not expand our international operations and successfully overcome the risks inherent in international business activities, the growth of our business will be limited.

We currently have very limited international operations. To be successful in the long-term, we must continue to expand our international operations and enter new international markets. If we do expand internationally, it will require significant management attention and financial resources to develop sales and support channels. Even if we successfully develop these channels, we may not be able to maintain or increase international market demand for our solution. In addition, our international operations are subject to a number of risks inherent in international business activities, including:

• the cost and challenges of customizing services for local markets and foreign languages;

• laws and business practices favoring local competitors;

• our dependence on local staff and vendors;

• compliance with multiple, conflicting and changing governmental laws and regulations, including tax laws and regulations;

• longer sales cycles;

• possible delays or greater difficulty in accounts receivable collection;

• import and export restrictions and tariffs;

• exposure to foreign currency exchange rate fluctuations;

• reduced protection of intellectual property rights and increased liability exposure; and

• regional, economic, cultural and political conditions, including the direct and indirect effects of terrorist activity and armed conflict in countries in which we do business.

If we are unable to successfully manage these risks, our international sales growth will be limited and our results of operations will be seriously harmed. We do not currently engage in currency hedging activities, but we may do so in the future.

Rapid changes in technology and industry standards could render our products and services unmarketable or obsolete, and we may be unable to introduce new products and services in a timely and successful way.

To succeed, we must continually change and improve our solutions in response to rapid technological developments and changes in operating systems and hardware, software, communication, browser and database technologies. We may be unable to successfully and promptly develop these new solutions or achieve and maintain market acceptance. The development of new, technologically advanced solutions is a complex and uncertain process that requires great innovation and the ability to anticipate technological and market trends. Because software development is complex, it can require long development and testing periods.

Releasing new solutions prematurely may result in quality problems, and releasing them late may result in loss of customer confidence and market share. Unforeseen circumstances may cause schedule delays in the introduction of new and enhanced solutions. When we do introduce new or enhanced solutions, we may be unable to manage the transition from the older solutions and may be forced to continue to support the older solutions at increased cost to us. In particular, our education customers often have older technical environments, which require us to maintain solutions that operate on multiple platforms.

If we delay release of our new solutions, or if they fail to achieve market acceptance when released, it could harm our reputation and our ability to attract and retain customers, and our revenues may decline. In addition, customers may defer or forego purchases of our solution if we, or our competitors introduce or announce new solutions or solution enhancements.

We may be unable to adequately protect our proprietary rights, which may limit our ability to compete effectively.

Intellectual property is critical to our success, and we rely upon trademark, copyright and trade secret laws in the United States and other jurisdictions to protect our proprietary technology and brands. None of our technology is patented. We rely on United States trade secret and copyright law to protect our proprietary search technology. We protect our proprietary rights through the use of intellectual property agreements with employees and consultants, which cover confidentiality, nondisclosure, and assignment of invention matters. Some of our former employees and consultants who may have had access to our proprietary information have not entered into these intellectual property agreements, although we believe that all intellectual property that is material to our business is covered by signed agreements. If we are incorrect in this assessment, our business could be seriously harmed.

Despite our efforts to protect our proprietary rights, unauthorized parties may copy aspects of our products and obtain and use information that we regard as proprietary. Other parties may breach confidentiality agreements and other protective contracts we have entered into, and we may not become aware of, or have adequate remedies in the event of, any breach. Trademark, copyright, and trade secret protection may not be available to us in every country in which our services are available. In addition, the laws of some foreign countries may not be as protective of intellectual property rights as United States laws, and mechanisms for enforcement of intellectual property rights may be inadequate.

Many of our products are dependent on third-party software or hardware.

Many of our products are dependent on third-party software or hardware providers, including our products that run on Microsoft ISA, Microsoft Proxy II, Novell Excelerator, Novell Border Manager, Cisco PIX Firewall, Cisco Content Engine, and Check Point Firewall-1. We depend on these third parties’ abilities to deliver and support reliable products, enhance their current products, develop new products on a timely basis and respond to emerging industry standards and other technological changes. If any of these third parties cease production of these products, change the design of their product such that it becomes incompatible with our products, delay the launch of future products or open their proprietary interface to the public, we could lose sales and we could incur additional costs to design around the incompatibility.

Intellectual property claims and litigation could subject us to significant liability for damages and result in invalidation of our proprietary rights.

In the future, we may have to resort to litigation to protect our intellectual property rights or to determine the validity and scope of the proprietary rights of others. In particular, we expect that as competition in the market for Internet filtering increases and as the number of patents relating to these products continues to increase, the potential for patent infringement claims against us will increase. Any litigation, regardless of its success, would likely result in significant expense to us and divert the efforts of our management and development personnel. In the event of an adverse result, we could be required to do one or more of the following:

• pay substantial damages, including treble damages;

• permanently cease use of any technology determined to be infringing;

• obtain a license for the technology, which may be on unfavorable terms;

• attempt to redesign our filtering services to avoid the infringement or to develop non-infringing technology, which we might not be able to do at an acceptable price, in a timely fashion or at all.

Our solutions may suffer from defects or errors, which could result in loss of revenues, delayed or limited market acceptance of our products, increased costs and damage to our reputation.

Complex software products such as ours frequently contain errors or defects, especially when first introduced or when new versions are released. Our customers are particularly sensitive to such defects and errors because they rely on our services for providing a content-safe Internet environment. Any significant defects or errors in our services or products may result in loss of revenues or delay in market acceptance, diversion of development resources, negative publicity, damage to our reputation or legal claims. Although our agreements with customers typically contain provisions designed to limit our exposure to potential legal liability, these limitation of liability provisions may not be completely effective. We have not experienced any liability claims to date, but we cannot assure you that we will not face this type of claim in the future. We maintain errors and omissions insurance, but we cannot assure you that this insurance coverage will adequately cover us for any claims.

Our systems may be vulnerable to security risks or service disruptions that could harm our business.

Our servers are vulnerable to physical or electronic break-ins and service disruptions, which could lead to interruptions, delays, loss of data or the inability to process user requests. Such events could severely damage our ability to service existing customers and activate new customers, and would be very expensive to remedy and could damage our reputation, discouraging existing and potential customers from using our services. In the past we have experienced unsuccessful attempts at electronic break-ins but we may experience break-ins in the future. Any such events could substantially harm our business, financial condition, and results of operations.

We have an Internet hosting agreement with a third party hosting provider, who houses the majority of our servers. Our network operations center is situated at the hosting provider in a single geographic location, and not all systems within this location are redundant. Our operations depend on their ability to protect our systems against damage from fire, earthquake, power loss, flood, telecommunications failures, vandalism and other malicious acts, and similar unexpected adverse events. Any major disruption in our services could take a substantial amount of time to remedy, and could diminish revenues, decrease customer and user confidence in our services and limit the growth of our business.

We may not be able to distribute our services abroad due to United States export laws, which could cause us to lose sales.

The encryption technology contained in our services and products is subject to United States export controls. These export controls limit our ability to distribute certain encrypted services and products outside of the United States. While we take precautions against unlawful exportation, such export inadvertently may have occurred in the past or may occur from time to time in the future, subjecting us to potential liability. Future legislation or regulation may further limit the encryption technology that we can include in our services and products. In addition, foreign governments have import and domestic use laws and regulations that restrict the types of permitted encryption software distributed in their countries. Such regulations could alter the design, production, distribution, and use of our services and products. Finally, some foreign competitors are subject to less stringent controls on exporting their encryption technologies. As a result, they may be able to compete more effectively than we can in U.S. and international markets.

If the use of the Internet in education and business does not grow, demand for our solutions will be limited.

The success of our services and products in the education market will depend, in large part, on the continued broad use and acceptance of the Internet as a source of information in educational settings. Schools, teachers and parents may cease to consider the Internet a viable research tool due to concerns over the potential exposure of students to unsuitable material, even with filtering services such as ours, or because of inadequate development of telecommunications and networking systems. Similarly, we are uncertain of the extent to which businesses will use the Internet as a means of communication and commerce and whether the market for Internet filtering solutions will continue to develop.

The Internet could lose its viability due to delays in the development or adoption of new standards and protocols to handle increased levels of Internet activity or due to increased governmental regulation. Cutbacks in technology funding could also limit use of the Internet in schools. If the necessary Internet infrastructure and complementary products are not developed on a timely basis, or if school and business use of the Internet experiences a significant decline, demand for our solutions may be limited.

The concentrated ownership of our common stock could delay or prevent a change of control, which could cause a decline in the market price of our common stock.

Our directors, executive officers and their affiliated entities beneficially owned a substantial percentage of our outstanding common stock. As a result, these shareholders may, as a practical matter, be able to exert significant influence over all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions such as acquisitions, and to block unsolicited tender offers. This concentration of ownership may delay, deter or prevent a third party from acquiring control over us at a premium over the then-current market price of our common stock, which could result in a decrease in our stock price.

Our articles of incorporation and bylaws, our shareholder rights plan and Washington law contain provisions that could discourage a takeover.

Some provisions of our Restated Articles of Incorporation and Amended Bylaws, our shareholder rights plan and Washington law, could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our shareholders. This could limit the price that certain investors might be willing to pay in the future for shares of our common stock.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk related to changes in foreign currency exchange rates and interest rates relating to debt and investment instruments. We have assets and liabilities denominated in certain foreign currencies related to our international subsidiary. We have not hedged our translation risk on these assets and liabilities. We do not expect that a sudden or significant change in foreign exchange rates would have a material impact on results of operations, financial position or cash flows. We believe the reported amount of cash equivalents at March 31, 2003 is a reasonable approximation of the fair value. As a result, we believe that the market risk arising from our holdings of financial instruments is minimal.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

The term “disclosure controls and procedures” is defined in Rules 13a-14(c) and 15d-14(c) of the Securities Exchange Act of 1934, or the Exchange Act. These rules refer to the controls and other procedures of a company that are designed to ensure that the information required to be disclosed by a company in the reports that it files under the Exchange Act is recorded, processed, summarized and reported within required time periods. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our Exchange Act reports is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Our chief executive officer and our chief financial officer have evaluated the effectiveness of our disclosure controls and procedures as of the Evaluation Date, which is a date within 90 days before the filing of this annual report, and they have concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective.

Changes in internal controls

There were no significant changes in our internal controls, or to our knowledge, in other factors that could significantly affect our disclosure controls and procedures subsequent to the Evaluation Date.

PART II—OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On July 25, 2002, Benjamin Edelman filed suit against us in the U.S. District Court for the District of Massachusetts. Mr. Edelman is purportedly a computer researcher who seeks to conduct a quantitative analysis of the accuracy and comprehensiveness of our “Bess” and “Sentian” Internet content filtering products. He seeks a declaratory judgment that he cannot be held liable for breach of certain provisions of the license agreement as a result of his proposed activities. In addition, Mr. Edelman seeks a declaration that he will not be prosecuted for violations of the Copyright Act of 1976, the Digital Millennium Copyright Act, or laws protecting trade secrets if he conducts his proposed analysis. Finally, Mr. Edelman seeks to enjoin us from initiating litigation against him on the basis of his proposed activities. We filed a Motion to Dismiss this action, which was granted. Judgment was entered in our favor on April 17, 2003. If Mr. Edelman decides to appeal, he has until no later than May 17, 2003 to do so.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

Not Applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not Applicable.

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

The Company held its Annual Shareholders Meeting on March 13, 2003 at which time the shareholders voted on the following proposals:

(1) To elect two Class III directors for a three-year term:


	Number of Shares

Name of Candidate	For		Withheld

Peter H. Nickerson		17,160,482		522,197
Dawn Trudeau		17,148,182		534,497

The aforesaid nominees have been elected as Directors for the term set forth above.

(2) To ratify the selection of PricewaterhouseCoopers LLP as the Company’s independent accountants:


For			17,373,823
Against			296,516
Abstain			12,340

The foregoing proposal was approved.

ITEM 5. OTHER INFORMATION

Not Applicable.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a) Exhibits:
99.1 Certification of Principal Executive and Financial Officers pursuant to 18 U.S.C. Section 1350

b) Reports on Form 8-K.

There were no reports on Form 8-K filed during the quarter ended December 31, 2002.

SIGNATURES

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


	N2H2, INC.

Dated: May 14, 2003	By:	/s/ Howard P. Welt Howard P. Welt
		President and Chief Executive Officer
		(principal executive officer)

Dated: May 14, 2003	By:	/s/ J. Paul Quinn J. Paul Quinn
		Vice President - Chief Financial Officer,
		Secretary and Treasurer
		(principal financial and accounting officer)

CERTIFICATIONS

I, Howard Philip Welt, certify that:

1. I have reviewed this quarterly report on Form 10-Q of N2H2, Inc. (N2H2);

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of N2H2 as of, and for, the periods presented in this quarterly report;

4. N2H2’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for N2H2 and we have:

a) designed such disclosure controls and procedures to ensure that material information relating to N2H2, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of N2H2’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. N2H2’s other certifying officer and I have disclosed, based on our most recent evaluation, to N2H2’s auditors and the audit committee of N2H2’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect N2H2’s ability to record, process, summarize and report financial data and have identified for N2H2’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in N2H2’s internal controls; and

6. N2H2’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: May 14, 2003

/s/ HOWARD PHILIP WELT

Howard Philip Welt
President and Chief Executive Officer
(Principal Executive Officer)

I, J. Paul Quinn, certify that:

1. I have reviewed this quarterly report on Form 10-Q of N2H2, Inc. (N2H2);

5. N2H2’s other certifying officer and I have disclosed, based on our most recent evaluation, to N2H2’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

Date: May 14, 2003

/s/ J. PAUL QUINN

J. Paul Quinn
Vice President, Chief Financial Officer, Secretary and Treasurer
(Principal Financial Officer)

EXHIBIT INDEX


EXHIBIT
NO.
99.1		Certification of Principal Executive and Financial Officers pursuant to 18 U.S.C. Section 1350

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	•		statements about our future capital requirements, our future cash flows and the sufficiency of our existing cash, cash equivalents, investments and available bank borrowings to meet these requirements;

	•		information concerning possible or assumed future results of operations, trends in financial results and business plans, including those relating to earnings growth and revenue growth;

	•		statements about the level of our costs and operating expenses relative to our revenues;

	•		other statements about our plans, objectives, expectations and intentions; and

	•		other statements that are not historical facts.

	•		actual or anticipated quarterly variations in operating results;

	•		announcements of technological innovations or new services or products by us or our competitors;

	•		changes in analysts’ earning projections or recommendations;

	•		our failure to meet or exceed analyst estimates;

	•		announcements of technological innovations;

	•		the introduction of new products;

	•		proprietary rights litigation or other litigation; and

	•		other events or factors, many of which are beyond our control.

	•		general economic conditions, which may affect our customers’ investment levels in enterprise software;

	•		the rate of market acceptance of new product introductions;

	•		budget and spending decisions by our customers;

	•		subscription renewal rates of our existing customers;

	•		our ability to compete in the highly competitive Internet filtering solutions market;

	•		the loss of any key technical, sales, customer support or management personnel and the timing of any new hires;

	•		our ability to develop, introduce and market new products and product versions on a timely basis;

	•		our ability to successfully expand our operations, and the amount and timing of expenditures related to this expansion;

	•		the tendency of our educational customers to budget and make purchases on the basis of a fiscal school year beginning in the fourth fiscal quarter of each year; and

	•		the length of our sales cycle, which varies substantially from customer to customer.

	•		we are unable to develop and maintain effective, long-term relationships with existing and potential key resellers;

	•		our existing and potential key resellers endorse products or technologies other than our solutions; or

	•		our existing and potential key resellers do not have or do not devote the resources necessary to effectively sell our solutions.

	•		the cost and challenges of customizing services for local markets and foreign languages;

	•		laws and business practices favoring local competitors;

	•		our dependence on local staff and vendors;

	•		compliance with multiple, conflicting and changing governmental laws and regulations, including tax laws and regulations;

	•		longer sales cycles;

	•		possible delays or greater difficulty in accounts receivable collection;

	•		import and export restrictions and tariffs;

	•		exposure to foreign currency exchange rate fluctuations;

	•		reduced protection of intellectual property rights and increased liability exposure; and

	•		regional, economic, cultural and political conditions, including the direct and indirect effects of terrorist activity and armed conflict in countries in which we do business.

	•		permanently cease use of any technology determined to be infringing;

	•		obtain a license for the technology, which may be on unfavorable terms;

	•		attempt to redesign our filtering services to avoid the infringement or to develop non-infringing technology, which we might not be able to do at an acceptable price, in a timely fashion or at all.

	a)		Exhibits: 99.1 Certification of Principal Executive and Financial Officers pursuant to 18 U.S.C. Section 1350

	b)		Reports on Form 8-K.

			There were no reports on Form 8-K filed during the quarter ended December 31, 2002.

	a)		designed such disclosure controls and procedures to ensure that material information relating to N2H2, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	b)		evaluated the effectiveness of N2H2’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect N2H2’s ability to record, process, summarize and report financial data and have identified for N2H2’s auditors any material weaknesses in internal controls; and

	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in N2H2’s internal controls; and