N2H2 INC, 10-K405, 2000-12-28

N2H2 INC
10-K405, 2000-12-28
COMMUNICATIONS SERVICES, NEC

Previous: TROY FINANCIAL CORP, 8-K, EX-99.1, 2000-12-28

Next: N2H2 INC, 10-K405, EX-10.22, 2000-12-28

<PAGE> 1

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

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------

FORM 10-K/405
------------------------

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

FOR THE FISCAL YEAR ENDING SEPTEMBER 30, 2000

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

FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .

COMMISSION FILE NUMBER 0-26825

N2H2, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S> <C>
WASHINGTON 91-1686754
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
</TABLE>

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

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, WITHOUT PAR VALUE

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. [X]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

As of December 7, 2000, the registrant had outstanding 22,367,675 shares of
common stock, no par value, and the aggregate market value of those shares
(based upon the closing price as reported by NASDAQ) held by non-affiliates was
approximately $11,183,838.

DOCUMENTS INCORPORATED BY REFERENCE:

(1) Portions of the registrant's definitive 2001 Proxy Statement to be filed
with the Commission are incorporated by reference into Part III hereof.

--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
<PAGE> 2

PART I

ITEM 1. GENERAL.

The following discussion in this annual report on Form 10-K contains
forward-looking statements regarding the Company, its business, prospects and
results of operations that involve risks and uncertainties. The Company's actual
results could differ materially from the results that may be anticipated by such
forward-looking statements and discussed elsewhere herein. Factors that could
cause or contribute to such differences include, but are not limited to, those
discussed herein as well as those discussed under the captions "risk factors"
and "management's discussion and analysis of financial condition and results of
operations" as well as those discussed elsewhere throughout this annual report
on Form 10-K.

Forward-looking statements typically are identified by the use of such
terms as "may," "will," "expect," "believe," "anticipate," "estimate," "plan,"
and similar words, although some forward-looking statements are expressed
differently.

Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date of this report. The Company
undertakes no obligation to revise any forward-looking statements in order to
reflect on events or circumstances that may subsequently arise. Readers are
urged to carefully review and consider the various disclosures made by the
Company in this report and in the Company's other reports filed with the
Securities and Exchange Commission that attempt to advise interested parties of
the risks and factors that may affect the Company's business, prospects and
results of operations.

N2H2, Inc. and its subsidiaries (together "N2H2") are a leading provider of
content filtering for the Internet. N2H2 creates hardware and software solutions
that allow Internet users to filter over 40 content categories thereby
increasing productivity, reducing bandwidth consumption, and limiting potential
legal liability.

We market our products through our direct sales force, re-sellers and
service providers. This multiple-channel approach allows customers to select the
channel that addresses their specific needs and provides us with broad coverage
of worldwide markets.

The N2H2 strategy is to provide Internet management and content filtering
solutions to the enterprise marketplace by leveraging its expertise in filtering
larger-scale networks in the sensitive environment found in the education
marketplace. N2H2 has three broad-based product lines -- servers (our
proxy-based filtering solution), a new MSP (Managed Service Provider) software
solution, and client-server hybrid targeted at ISPs and affinity groups.

N2H2 was incorporated in Washington in June 13, 1995 and is headquartered
in Seattle. The mailing address for our headquarters is 900 Fourth Avenue, Suite
3600, Seattle, Washington 98164, and our telephone number at that location is
206-336-1501. We can also be reached at our website, http://www.n2h2.com.

FILTERING SOLUTIONS AND TECHNOLOGY

N2H2 Internet Filtering -- Our MSP Software plug-in Filtering Solution

Our new MSP software plug-in solution targets enterprise level (corporate
and government) customers*. N2H2 has developed applications that reside on a
customer's server, behind (or on) the network firewall. This solution is
designed to be downloadable from the Internet and installed by the customer.
N2H2's database of Internet content, typically delivered daily, is provided to
the product via a secure "pull" method that is designed to allow the customer
the ability to download the database without opening their firewall to external
intrusion.

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

* The MSP model is defined here as the delivery of system management services
over a network on a subscription basis to IT departments and other customers
who manage their own technology assets (source: MSP Association).
1
<PAGE> 3

The N2H2 Internet Filtering family of solutions harnesses N2H2's newest
filter engine technology to deliver fast Internet filtering at the server level.
Unlike N2H2's traditional proxy server model, this new solution is customer
administered and not directly managed by N2H2, allowing network administrators
to implement and tune the solution to meet their specific performance needs.

This solution has a user interface that allows the customer to tailor the
filtering profiles for the organization by selecting categories to "block" from
N2H2's extensive Internet category list. The solution also allows the customer
to generate log files of Internet usage by user name and group (vs. IP address)
that can be stored on the server or transferred to a separate server for secure
and/or long-term storage. The solution also has a standard reporting suite that
allows system administrators and managers the ability to view Internet usage
patterns of the organization.

N2H2 Internet Filtering solutions will be available on major enterprise
grade hardware and operating systems platforms.

N2H2 Internet Filtering Manager -- Our Client-based Filtering Solution

The solution's primary target audience is ISPs or affinity groups that
serve the home user and small businesses. The client product is a PC-based
layered service provider (LSP) operation. Named the N2H2 Internet Filtering
Manager, it communicates with the filtering engine to determine if a site is
blocked or allowed. If blocked, the browser is directed to a block page. The
filtering engine resides outside the user's PC (for example, on the server at
the user's ISP), allowing for daily updates from the N2H2 database of Internet
content via "push" methods, keeping the local database current and accurate.

The design of the client product easily allows modifications to logos and
title bars via separate resource files to facilitate a co-branding
option -- affording interested customers (ISP and affinity groups) the ability
to extend their brands via this product.

To pass enhancements to the user-base, the software automatically performs
a daily check with an "update" server to see if a newer version is available.
This check occurs when the browser is launched and the filtering is on. If a
more current version of the client software is available, the user has the
option to download or postpone the download of the updates.

I2100, G2100, and I1100 Servers -- Our Proxy-based Filtering Solution

Our on-site proxy servers are shipped to customers ready to install into
their networks. N2H2 proxy servers are a combination of readily available
computer hardware, including a high capacity hard drive and a high-speed network
connection, purchased from outside suppliers. We configure these servers with
software developed by us that enables the filtering functions. We also monitor
and maintain all the software and hardware components necessary to meet our
customers' filtering needs remotely from our Seattle network facility. Our
filtering solutions have three main components:

- a proxy server infrastructure,

- our advanced Internet content categorization system, and

- tools for filter control, reporting and data collection.

Proxy server infrastructure: configurations and caching. Rather than
installing a filter on every workstation, as is necessary with client-based
products, our solution uses a proxy server that is usually installed on the
customer's network. Every networked workstation uses our filtering solution to
access the Internet.

Proxy server-based systems are secure and difficult to bypass because the
proxy server is installed directly in the network, thus making it virtually
impossible for users to access the Internet without passing through this server.
From a customer's point of view, a proxy-based system is easy and economical to
operate because we manage it from a central site. The parameters our clients use
to control the filtering of their Internet content are stored by the proxy
server located on their networks and are based on information received from our
central database of categorized Web sites. This information is updated and sent
to our customers' proxy

2
<PAGE> 4

servers daily. In addition, we also send system upgrades and enhancements to our
customers' proxy servers via the Internet. In most cases, we provide on-site
proxy server configuration to our clients; however, for smaller networks, we
offer a "redirect" service that enables multiple customers to share one
regionally located proxy server.

N2H2's operating infrastructure has been designed and implemented to
provide high system availability and to support remote management and
maintenance of thousands of servers handling millions of user requests per day.
Our production filtering systems are individually designed and configured to
support unique and disparate customer network and performance requirements. This
scalability enables us to provide effective solutions to a wide range of
customers, from small organizations with less than 100 Internet users, all the
way up to statewide-managed networks.

N2H2 proxy servers are built by ISO9002 certified hardware vendors
utilizing industry standard hardware components easily obtained from commercial
sources. N2H2 proprietary filtering software can be deployed on a broad range of
platforms, including Microsoft, Sun, IBM, Linux, and Novell. Our standard I2100
and I1100 filtering proxy servers run on the Linux operating system and use
custom-developed filtering proxy server software. Our internal production
servers run on Linux, Sun Solaris, and Microsoft NT operating systems and use
custom-developed software in addition to Apache, Microsoft SQL Server, and
Sybase Adaptive Server Enterprise.

Searchopolis(SM)

Searchopolis, N2H2's filtered search engine, combines the following key
features:

- Safe search. Searchopolis includes our pioneering, proprietary filtering
technology operated in conjunction with Inktomi's search technology.
Searchopolis is designed to enable the user to find educational resources
quickly and navigate safely through the Internet.

- Focused educational content. The Searchopolis Education Resource Center
includes access to searches by comprehension level, an Education Web
allowing users to search a listing of approximately 5 million
non-commercial Web pages, an Expert Picks search of the Web's most
relevant education sites, daily fun facts, and advanced searching
capabilities

Advanced Internet Content Categorization System

The selectable filtering criteria available to our clients are based on our
listing of Internet content categories. In our Web site categorization process,
we employ a multi-step procedure using automated search technology backed by
human review to place Internet content into over 40 categories, with 33 distinct
categories and relevant sub-categories. Automated search is used to scan the
Internet on a continuous basis to quickly identify Web sites that potentially
fit into these categories. We employ a wide variety of techniques for this part
of our automated categorization process including artificial intelligence,
keyword search, and site associations and linkages. Once a Web site has been
identified as fitting into one or more of our categories, it
is stored in a database and prioritized for human review. For details on
categories, see
http://www.n2h2.com/solutions/filtering.html.

Our customers have the flexibility to select which, if any, of the
exceptions to these categories they wish to enable. Categorized sites are stored
in a proprietary database located at our headquarters. The contents of this
database are continuously updated using both human and automated review and
reflect the introduction of new sites on the Internet and changes to sites we
previously categorized. Each day, our customers receive electronically an
encrypted copy of the Web site categorization information stored in this
database.

Our central servers maintain a log of Internet data retrieval requests and
the workstations that originated the request. However, this process does not
provide us with information about the identity of the individual originating the
request. In some instances, our clients may maintain information regarding the
identity of users on a particular workstation at a given time.

3
<PAGE> 5

PROFESSIONAL SERVICES

N2H2's professional consulting division is a group of experienced
professional consultants who help companies understand how Internet use and
advertising impact their organization's bandwidth costs, employee productivity,
and legal exposure. This includes expertise in the areas of intelligent Internet
filtering, content categorization, Internet usage policy development, and
bandwidth optimization.

Internet Usage Assessment (IUA)

N2H2's Internet Usage Assessment (IUA) is a consultative service that helps
transform confusing and unwieldy network data into meaningful information for an
organization. A complete IUA report provides a comprehensive picture of Internet
use on a network. The IUA serves high-level executives or administrators of
corporate entities and federal, state, and local government agencies with
Internet-capable computer networks. The IUA report does not simply summarize raw
log data; rather, it analyzes log data and resolves page views, time spent per
page, and user sessions. Our consulting division analyzes a database of page
views derived from the raw data.

Class Clicks(R)

Class Clicks is a new syndicated Web audience measurement service produced
in partnership with Roper Starch Worldwide, a leading global marketing research
and consulting firm. Class Clicks is designed to deliver key audience metrics on
visits, time spent, and page views for the top 1,000 Web Sites accessed by
students in U.S. K-12 schools. Class Clicks is designed to offer valuable
Internet intelligence to:

- Web Sites with sizable K-12 in-school audience

- e-Learning sites get objective measurement of audience size and
quality

- E-Commerce sites use metrics to support advertising rates

- Advertisers

- Use Class Clicks intelligence to better reach the Internet youth
market

- Gain understanding of "hot sites," trends, and youth interests to
guide their advertising and brand development strategies

- Media Buyers and Advertising Agencies

- Use Class Clicks to develop and evaluate Internet advertising plans

- Underwriters, Investors & Analysts

- Track the health of youth oriented dot-com businesses

- Use the reports to establish independent measurements of site
traffic

RESEARCH AND DEVELOPMENT

N2H2's move toward the MSP model comes as we complete our entry into the
enterprise space. This transition leverages our market leadership position in
the education marketplace, filtering large-scale networks within sensitive
environments. We are currently developing filtering technology for the new
Microsoft Internet Security and Acceleration (ISA) Server 2000, a new enterprise
firewall and Web cache server designed to help organizations protect,
accelerate, and control their network access. A private beta testing launched in
December 2000. We expect to release the final version simultaneously with
Microsoft's release of ISA Server 2000, which is currently scheduled for first
quarter of calendar year 2001. N2H2 Internet Filtering for Microsoft ISA Server
2000 is designed to allow organizations to maximize limited network resources
and reduce bandwidth consumed by unnecessary Internet traffic through combining
ISA Server 2000's caching and firewall capabilities with N2H2's Label Server
technology.

4
<PAGE> 6

FEE STRUCTURE

Education Marketplace: We generate our revenues primarily from installation
and subscription fees charged for our filtering solutions, consulting fees, and
advertising fees. Beginning in November 2000, N2H2 made a strategic move away
from the Bess Partner Program (BPP), our advertising model in education. When we
officially initiated this model in September 1999, our goal was to increase
market share by making filtering more accessible to schools through a choice of
either fee-based filtering or an advertiser-supported offering. Now, with
Internet advertising softening industry-wide -- contributing only 13% of our
revenues in the fourth quarter fiscal year 2000 -- we are transitioning toward
offering our services on a fee-only basis. N2H2 will continue to provide
filtering under the ad-based model through the end of this school year.
Advertising revenues will decrease in the future as we transition to the
fee-based model in the education marketplace.

Enterprise Marketplace: We generate our revenues primarily from
installation and subscription fees charged for our filtering solutions, and
consulting fees.

CUSTOMERS

N2H2 provides filtering services to a customer base that includes the
following:

Enterprise and Government Entities. Enterprise customers are a growing part
of our customer base. As corporate managers become increasingly concerned about
bandwidth conservation, productivity and liability issues related to employee
Internet usage, we believe the corporate market will present us with significant
opportunities. Enterprise customers generally are large organizations with 500
or more employees with complex networking needs, usually spanning multiple
locations and types of computer systems. Enterprise customers include
corporations and government agencies. Small/medium-sized businesses have less
than 500 employees and a need for networks of their own, as well as connection
to the Internet and to business partners. Since small/medium-sized businesses
generally have limited expertise, we target services that are affordable and
easy to install and use to these customers.

International. N2H2's strategic partnerships market to corporations,
consumers, and schools internationally. We provide services to customers in
countries including Canada, Australia, Japan, the United Kingdom, Germany,
Switzerland, Korea, Chile, Mexico, and China. We believe the demand in the
international market will continue to present us with significant opportunities.

ISP/Affinity Groups. These customers provide Internet services to
businesses and consumers. They include regional, national, and international
long distance telecommunications carriers, as well as Internet, cable, and
wireless service providers. We currently provide our filtering services to homes
through approximately 280 Internet service providers. Some of these ISPs may
also serve as re-sellers of our services to small businesses and schools. We
provide our core technology for filtering, filtered search and portal
development to affinity groups, who purchase our filtering services for their
own members. They also purchase from us filtered search services to include on
their own affinity group portals.

Schools. Our school customers range from single schools to statewide
systems.

SALES AND MARKETING

Organization

N2H2 has achieved substantial market share within the education marketplace
where, historically, we have used a direct sales force. N2H2's sales activities
are now focused on our enterprise marketplace products. This move into the
enterprise marketplace, however, leads us to believe that the direct sales
approach will not successfully translate. Therefore, we are implementing such
practices as telesales for qualified leads generation, resellers, new
partnership relationships, and pipeline management and control procedures. To
accomplish this shift, we are aligning ourselves with a professional telesales
organization to generate qualified leads. We are continuing to establish
relationships with corporate resellers as we expand internationally and move
further into the enterprise space. We have sales representatives concentrating
on selling our solutions to

5
<PAGE> 7

regional and larger Internet service providers throughout the world. We have
senior sales representatives dedicated to developing sales in the enterprise and
international markets directly and indirectly through our partnerships with
major technology and marketing companies, as well as developing relationships
with key Internet service providers and virtual ISP groups.

We are also concurrently aligning our sales activities to maintain our
leadership position within the education marketplace.

N2H2's worldwide direct sales and marketing organization at November 30,
2000 consisted of approximately 40 individuals, including managers, sales
representatives, and technical support personnel. We have field sales offices in
the United Kingdom and Australia. Currently, N2H2 has 25 resellers in the
international arena and provides filtering services to Interactive TV providers,
ISPs, and schools located in the United Kingdom, Australia, China, Switzerland,
and Latin America. N2H2 continues working with its partner, Nissho Electronics
in Japan, to extend and support infrastructure and technical implementation and
build Nissho's expertise in the filtering market. Nissho Electronics currently
has eleven corporate customers and is expanding its operations.

Our customer base crosses industry lines and is not concentrated within any
particular industry. In each of the past five fiscal years, no single customer
has accounted for 10 percent or more of our net sales.

Marketing

Promotional emphasis has shifted from the education to the enterprise
marketplace. As new products are developed, we expect to launch and promote them
using a variety of tactics, including:

- Direct Marketing. Traditional direct mail and e-mail messages will be
targeted at qualified sales prospects.

- Online Marketing. N2H2's Web site, www.n2h2.com, will be more intensively
used to provide sales prospects with relevant product information and
downloadable demo versions of filtering products. By maximizing the
self-service sales potential of the web, we intend to lower our overall
cost of sales.

- Public Relations. We retain the services of public relations firms with
the objective of securing favorable product reviews and general
commentary.

- Trade Shows. Carefully selected industry events have proven effective in
building awareness and in generating sales leads.

- Advertising. Limited print and online advertising are used to target
market niches and to complement the overall marketing strategy.

STRATEGIC RELATIONSHIPS

The Online Curriculum Partner Program was created to provide a "Learning
Zone" which serves as an online curriculum resource center for teachers and
administrators, and has since been renamed the "Preview Zone." Its purpose is to
drive subscriptions and increase visibility in the education market for online
curriculum publishers. N2H2 receives revenue for ad placement on Searchopolis as
well as a percentage of any subscriptions purchased by end-users to the
partner's offering. There are currently three partners: Riverdeep Interactive
Learning, Cognitive Technologies Corporation, and Learning Outfitters. At this
juncture, the results have been disappointing. This is mainly due to a slow
adoption of online curriculum by the education market.

6
<PAGE> 8

CUSTOMER SERVICE AND SUPPORT

The N2H2 Network Operations Center (NOC) provides post-installation support
to customers in the following areas: monitoring, repair and trouble tracking,
N2H2-owned equipment maintenance and/or replacement, data collection and
analysis, service changes, and general technical support and customer service.
In addition to the aforementioned services, N2H2 provides contracted network
design and configuration consulting at N2H2's then-current rates. The NOC is
staffed 24 hours a day seven days a week by skilled representatives available
and trained in network diagnostics, server diagnostics, general system
engineering, N2H2 software and hardware, TCP/IP, and remote circuit management.
At all times, there is an on-call Level II analyst available via pager for
escalated issues.

COMPETITION

We face five major competitors in the server-based Internet filtering
industry, along with a number of smaller competitors. Our major competitors are
Surf Control's SuperScout and CyberPatrol, Websense, Elron Software's Internet
Manager, Symantec's I-Gear, and Secure Computing's SmartFilter. We have more
market share in the education space than all five of these competitors combined,
but we are behind all of these competitors in the enterprise space. We are
primarily behind because we have come later than our competitors to the
enterprise space, and because we are only now moving to implement what we
believe is the necessary business model for success in the enterprise space:
selling software on multiple widely accepted platforms.

INTELLECTUAL PROPERTY

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. N2H2, BESS and
SEARCHOPOLIS are U.S. registered service marks. We have also applied in the U.S.
to register the N2H2, Bess and Searchopolis logos, VIRTUAL LOCKER and DELIVERING
THE WEB YOU WANT, and have filed foreign applications for most of these marks.
These applications may not be granted. In addition, any of our marks may be
challenged by others or invalidated through administrative process or
litigation. None of our technology is patented. United States trade secret and
copyright law protect our proprietary search technology. We own and operate the
servers that provide our proxy-based filtering services. 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 wrong in this assessment, our business could be seriously
harmed.

Trademark, copyright, and trade secret protection may not be available to
us in every country in which our services are available. 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. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to obtain, copy, and use our proprietary
technology.

REGULATORY AND LEGISLATIVE ISSUES

As use of the Internet has become more prevalent and various negative
issues associated with the Internet have received increasing amounts of
publicity, there has been a correspondingly greater amount of governmental
attention directed to the Internet in the United States Congress and elsewhere.
While various pieces of legislation regulating different aspects of the Internet
and Internet-related activity have been proposed, to date there has been no
legislation enacted which places any direct and substantial regulatory burden on
N2H2. Nonetheless, we anticipate further attempts to regulate Internet-related
activity, some of which may impose substantial burdens on our ability to do
business.

There has been a public-policy debate regarding Internet filtering in
schools and libraries within the U.S. Congress. This has resulted in the
Children's Internet Protection Act, a bill recently passed and signed into
7
<PAGE> 9

law mandating Internet filtering in schools and libraries receiving certain
federal funds, among other requirements. It should be noted, however, that there
might be considerable controversy with the implementation of this legislation,
which may hinder the pace of implementation.

We have never been party to a lawsuit regarding users acquiring
inappropriate content through our system. Management believes this is unlikely
in the future, partly because of the protections provided under Section 509 of
the Telecommunications Act of 1996 for organizations that provide filtering
tools or employ them. Our customer contracts do not provide for a guaranteed
level of filtering performance, and we do not intend to offer guarantees in the
future.

The Copyright Office recently issued a final rule interpreting the
provisions of the Digital Millennium Copyright Act ("DMCA") that prohibit the
circumvention of technological copyright protection mechanisms (the "Final
Rule"). The Final Rule took effect on October 28, 2000, and created an exemption
to the DMCA anti-circumvention provisions for compilations consisting of lists
of Web sites blocked by filtering software applications. The consequence of the
Final Rule is that lists of Web sites blocked by filtering software do not
receive extra protection under the DMCA, and technological measures used to
prevent access to such lists may be circumvented without violating the new
"anti-circumvention" provisions Copyright Act.

N2H2 considers its lists of blocked Web sites to be proprietary, valuable
information. However, N2H2 does not believe that the Final Rule will affect the
value of its lists of blocked Web sites. N2H2 regards its lists as trade secrets
and protects their confidentiality primarily through physical security controls
and contractual non-disclosure provisions. The Final Rule simply exempts lists
of blocked Web sites from the new copyright law protections available under the
DMCA, so that the level of copyright law protection available for such lists is
the same as it was before the DMCA was enacted in 1998.

EMPLOYEES

As of September 30, 2000, we employed 274 full time equivalent staff
worldwide. On October 13, 2000, the Company announced it had streamlined its
operations. As a result of these efforts, as of November 30, 2000, we employed
240 full time equivalent staff worldwide. As necessary, we supplement our
regular employees with temporary and contract personnel.

RISK FACTORS

You should carefully consider the following risk factors and all other
information contained in this Form 10-K before making an investment decision
regarding our common stock. Investing in our common stock involves a high degree
of risk. The risks described below are not the only ones that we may face.
Additional risks that are not yet identified or that we currently think are
immaterial may materially adversely affect our business and financial condition
in the future. Any of the following risks could seriously harm our business,
financial condition, and operating results and could result in a complete loss
of your investment.

WE HAVE A LIMITED OPERATING HISTORY AND A HISTORY OF LOSSES.

We have a limited operating history. Risks and uncertainties inherent in an
investment in N2H2 include, but are not limited to the following:

- we are an Internet company in the early stages of development,

- our limited history makes evaluation of our prospects difficult,

- our market is rapidly evolving and highly competitive, and

- 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, and $39.3 million for 2000. We anticipate that we will
continue to incur net losses for the foreseeable future.

8
<PAGE> 10

OUR FUTURE OPERATING RESULTS ARE UNCERTAIN.

We will continue to incur operating expenses, although at a reduced level
(as announced in early October 2000), before we receive any substantial revenues
from these expenses. Operating expenses in 2001 and beyond will include:

- sales and marketing costs,

- research and development costs,

- increased depreciation expenses related to installing additional servers
in customers' networks, and

- expanding our customer support and service operations.

We will need to significantly increase our revenues to achieve and maintain
profitability. Although our revenues have grown in recent quarters, we may not
be able to continue this growth or achieve or maintain profitability. We may
also fail to accurately estimate and assess increased operating expense
requirements as we grow. If we fail to achieve and maintain profitability, our
future capital raising efforts and planned growth of our business would be
seriously harmed.

WE ARE DISCONTINUING FREE FILTERING FOR SCHOOLS, AND OUR FUTURE REPLACEMENT OF
LOST ADVERTISING REVENUE IS UNCERTAIN.

We are terminating the advertising-based fee structure previously offered
to schools. Customers currently under this model will be converted to an
alternative fee structure. We cannot assure you that customers will accept our
alternate fee structure. Even if they accept the alternate fee structure, we
cannot assure you that we will receive enough fee-based revenues to make up for
lost advertising fees. Furthermore, schools customers are parties along with the
Company to contracts which may not allow unilateral termination by either party.
As a result, any unilateral termination by the Company of these contracts may
give rise to liabilities associated with breach of contract claims.

Through fiscal 1999, we have derived substantially all of our revenues
through a combination of subscription and installation fees for our filtering
services. Our subscription revenues were $548,000 for 1997, $1.7 million for
1998, and $3.8 million for 1999; and our installation revenues were $570,000 for
1997, $1.4 million for 1998, and $1.8 million for 1999. As a percentage of total
revenues, subscription revenues represented 49% for 1997, 56% for 1998, and 57%
for 1999. For fiscal 2000, subscription revenues were $4.3 million, or 39%, of
total revenues; and installation revenues were $4.1 million, or 37%, of total
revenues. Advertising contributed $2.4 million, or 22%, of total revenues for
the year. While our advertising revenues are expected to be substantially
eliminated, we anticipate, but cannot guarantee, that they will be replaced by
fee-based revenues.

OUR STOCK MAY BE DELISTED FROM NASDAQ.

At the time of filing, our stock price has closed below $1.00 per share for
29 consecutive business days. If at any time the bid price for N2H2's common
stock falls below $1.00 per share for a period of thirty consecutive business
days, the Nasdaq National Market System has the right to delist the stock if
within ninety days thereafter the bid price for the stock is not at least $1.00
per share for a minimum of ten consecutive business days. In the event our stock
price did not rise above $1.00 for the required ten consecutive business days,
we would have the right to request a hearing to appeal a determination that our
stock should be delisted. There is no guarantee that we would prevail in such a
hearing. If our stock were delisted, the delisting could have an adverse affect
on the price of our common stock and could adversely affect the liquidity of the
shares held by our shareholders.

9
<PAGE> 11

OUR QUARTERLY FINANCIAL RESULTS FLUCTUATE AND MAY BE AFFECTED BY SEASONAL
VARIATIONS.

Our quarterly operating results have fluctuated significantly in the past
and will continue to fluctuate in the future. Operating results vary depending
on a number of factors, many of which are outside our control, including:

- it is difficult to project the rate of market acceptance of new product
introductions,

- quarterly cash flows from subscription payments are difficult to forecast
because the sales cycle, from initial evaluation to delivery of services,
varies substantially between customers,

- we typically receive subscription payments in advance of the costs
directly associated with delivery of monthly services over the term of
the 12 month contract, making it difficult to associate costs with cash
flows,

- our educational services customers typically budget and purchase goods
and services on a fiscal school year basis beginning in August of each
year, and

- user traffic on our school customer systems has historically been lower
during the summer and during year end vacation and holiday periods.

Due to the combination of these and other factors, quarter to quarter
comparisons of operating results are not necessarily meaningful or indicative of
future performance. Further, it is possible that in some future quarter or
quarters our operating results will not meet or exceed the expectations of
public market analysts or investors. If that happens, or if adverse conditions
prevail or are perceived to prevail, either for our business or the market
generally, the market price of our common stock could be seriously harmed.

OUR SUCCESS DEPENDS ON CONTINUED MARKET ACCEPTANCE AND OPERATION OF OUR INTERNET
FILTERING SERVICES.

If we are unable to continue to solve our customers' Internet content
filtering problems, we will experience diminished revenues and the growth of our
business will be impaired. We currently receive, and expect to continue to
receive, a substantial portion of our revenues from our Internet filtering
services. 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 services. We cannot assure you that
we will be successful in upgrading and continuing to sell our Internet filtering
services or that any new products or services that we may develop or acquire
will achieve market acceptance. Any failure to upgrade our services or products
or to maintain our market acceptance could seriously harm our business,
financial condition, and results of operations.

OUR FILTERING CATEGORIZATIONS ARE SUBJECTIVE, AND WE MAY FAIL TO FILTER ALL
POTENTIALLY OBJECTIONABLE CONTENT.

We may not succeed in sufficiently filtering Internet content to meet our
customers' expectations. We rely upon a combination of automated filtering
technology and human review to categorize Web site content through our filtering
services and on Searchopolis. The total number of Web sites and partial Web
sites is growing rapidly. A partial Web site is a graphic image, text or other
visual appearing as a part of a full Webscreen display. We rely upon our staff
of reviewers to place Internet content into our more than 40 content categories.
We cannot assure you that our filtering technologies will successfully block all
potentially objectionable Internet content. 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 would
generate negative publicity which would impair the growth of our business and
our efforts to increase brand awareness.

10
<PAGE> 12

OUR ABILITY TO MANAGE GROWTH IS UNPROVEN.

Potential growth is likely to place a significant strain on our managerial,
operational, financial, and other resources. Our future success will depend, in
part, upon the ability of our senior management to manage growth effectively.

WE MAY FAIL TO COMPETE SUCCESSFULLY WITH OTHER PROVIDERS OF INTERNET FILTERING
SERVICES.

The market for our services and products is intensely competitive and
rapidly changing. Many of our competitors are larger and have substantially
greater resources than us. Our primary competition comes from keyword, Universal
Resource Locator, and packet filtering software applications. Although we
believe our products provide a better quality filtering service, these products
are significantly less expensive than our filtering services and can often be
downloaded for free over the Internet.

We compete directly with a number of Internet content management firms,
including publishers and distributors of traditional media and general-purpose
consumer online services such as America Online and Microsoft Network. Although
we believe the Internet provides opportunities for more than one provider of
content filtering services similar to ours, one or more of our competitors may
eventually dominate the sector. Further, we have only recently begun to provide
these services, and competitors' products and services may achieve greater
market acceptance than ours.

Increased competition could result in price reductions, reduced
profitability, or loss of market share, any of which would seriously harm our
business, financial condition, and results of operations.

WE WILL NEED TO ESTABLISH AND MAINTAIN STRATEGIC RELATIONSHIPS.

N2H2 pursues strategic alliances with other industry leaders in areas where
collaboration can produce industry advancement and acceleration of new markets.
The objectives and goals for a strategic alliance can include one or more of the
following: technology exchange, product development, joint sales and marketing,
and new market creation. This year, N2H2 expanded or entered into alliances with
Microsoft, AT&T, RadWare, CacheFlow, Compaq, Gateway, and Sun Microsystems,
among others. We depend on strategic relationships to offer services and
products to a larger customer base than can be reached through our direct sales
efforts. We have a strategic relationship with Inktomi for operating our
filtering search technology. Our plans for developing our international business
rely on additional strategic relationships. We cannot assure you that we will be
able to maintain and expand our strategic relationships or enter into new
strategic relationships or that these new relationships will be on commercially
reasonable terms.

If we are unable to maintain and expand our existing strategic
relationships or enter into new strategic relationships, we will need to use
substantially more resources to develop, distribute, sell, and market our
services and products than planned. We would also lose the customer
introductions and co-marketing benefits that we anticipate from such strategic
relationships. Our success will depend both on the success of the other parties
to these relationships and on their ability to market our services and products
successfully. Most of these companies have multiple strategic relationships, and
we cannot assure you that they will regard their relationships with us as
significant for their own businesses. If any of these firms fail to effectively
promote our services or products, our business, financial condition, and results
of operations will be seriously harmed through decreased growth opportunities.

WE ARE DEPENDENT ON KEY INDIVIDUALS WHO MAY BE SUBJECT TO CONFLICTING DEMANDS.

Our success depends on the performance of our senior management, including
Peter H. Nickerson, our President, Chief Executive Officer and Chairman of the
Board. We have entered into employment agreements with members of senior
management of various terms. Mr. Nickerson is also a principal of Nickerson &
Associates, an econometric and data management consulting company, and he
performs consulting services for that firm that could impose conflicting demands
on his time.

11
<PAGE> 13

OUR SUCCESS DEPENDS ON OUR ABILITY TO ATTRACT AND RETAIN QUALIFIED AND
EXPERIENCED EMPLOYEES.

We face a significant risk from a loss of any member of our senior
management team or any key employee, particularly if they join or form a
competitor. These risks relate mainly to:

- the loss of such individual's skills and talent,

- the resulting loss of existing or potential customers, or

- the unauthorized disclosure or use of our technical knowledge, practices,
procedures or customer lists.

Loss of a key employee could seriously harm our business, financial
condition, and results of operations. We cannot assure you that in such an event
we would be able to recruit personnel to replace our senior management in a
timely manner and on acceptable terms.

We expect there will continue to be competition for experienced
engineering, sales, and consulting personnel, particularly in the Internet
market. Many of the companies we compete against for experienced personnel have
greater resources than us. Competition in the Seattle area for these personnel
is particularly intense, and we cannot assure you that we will be successful in
attracting and retaining qualified personnel. As a result, 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.
Either of these occurrences could seriously harm our business, financial
condition, and results of operations through increased costs of doing business
and decreased demand for our services.

EXPANDING OUR INTERNATIONAL OPERATIONS EXPOSES US TO A NUMBER OF RISKS.

We currently have very limited international operations. Our Internet
filtering solutions revenues from customers outside the United States (primarily
in the United Kingdom, Australia, and Canada) represented approximately $84,000
in fiscal 1998, $158,000 for fiscal 1999, and $571,000 for fiscal 2000. As a key
component of our business strategy, we intend to expand our international sales
and support operations, and for that purpose we hired a European operations
director in June 1999, created N2H2 Limited (a wholly owned subsidiary formed
under the laws of the United Kingdom) in August 1999, and acquired iseek, Ltd.
(a company formed under the laws of Australia) in February 2000. Our ability to
expand our international operations is subject to a number of risks, including:

- our ability to customize 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, and

- uncertainties regarding transactions in foreign currencies.

If we are unable to successfully manage the risks associated with our
international operations, our international sales growth will be limited and our
results of operations will be seriously harmed. Currently, we do not engage in
or intend to engage in hedging.

OUR SERVICES MAY HAVE LIMITED INTEROPERABILITY AND MAY NOT KEEP PACE WITH RAPID
TECHNOLOGICAL CHANGES.

We may fail to develop filtering services compatible with future operating
systems, and we may not keep pace with technological advances. Our Internet
services are designed to operate with a variety of hardware and

12
<PAGE> 14

software used by our customers. Our school customers may use older operating
systems, however, requiring us to maintain multiple service platforms at
increased cost to us. In addition, we must continuously modify and enhance our
services to keep pace with changes in hardware, software, communication, browser
and database technology. Uncertainties about the timing and nature of vendors'
new product announcements or their introduction or modification of operating
systems would require increased research and development expenses. The failure
of our services to operate effectively across existing and future versions of
hardware and software used by customers would limit or reduce the market for our
services, result in customer dissatisfaction and seriously harm our business,
financial condition and results of operations.

WE HAVE LIMITED PROTECTION OF OUR INTELLECTUAL PROPERTY AND PROPRIETARY
TECHNOLOGY.

We may fail to adequately protect our intellectual property and proprietary
technology. 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. N2H2 and Bess
are registered United States service marks. We have also applied to register
Searchopolis and Virtual Locker as trademarks. These trademark applications may
not be granted. In addition, any of our trademarks may be challenged by others
or invalidated through administrative process or litigation. None of our
technology is patented. Our proprietary search technology is protected by United
States trade secret and copyright laws. We own and operate the servers that
provide our filtering services. We protect our proprietary rights through the
use of intellectual property agreements with employees and consultants covering
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 wrong in this assessment,
former employees could use our proprietary technology without our having an
effective remedy, and our business would be seriously damaged.

MANY OF OUR PRODUCTS ARE DEPENDENT ON THIRD-PARTY SOFTWARE.

Many of the Company's new products are still in development and are being
designed to be dependent on third-party software. If any of these third-party
software developers (i) cancel plans for their software, (ii) change the design
of their software resulting in incompatibility with the Company's products, or
(iii) delay the launch of their software, it may have a negative impact on
N2H2's business, financial condition and results of operations. As one example,
in December 2000, N2H2 released the beta version of its filtering technology for
the new Microsoft Internet Security and Acceleration (ISA) Server 2000. N2H2
plans to release its final version simultaneously with Microsoft's release of
ISA Server 2000, currently scheduled for the first quarter of calendar year
2001. Since the Company's sales of its filtering technology is dependent upon
Microsoft's timely launch of the ISA Server 2000, any cancellation or delays by
Microsoft in its release of ISA Server 2000 may have a negative impact on N2H2's
business, financial condition, and results of operations.

WE ARE SUBJECT TO RISKS OF INFRINGEMENT.

Trademark, copyright and trade secret protection may not be available to us
in every country in which our services are available. 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. Despite our efforts to protect our proprietary rights,
unauthorized parties may obtain, copy and use our proprietary technology. We
expect that it will become more difficult to monitor use of our services as we
increase our international presence. We cannot assure you that our means of
protecting our proprietary technology and brands will be adequate or that our
competitors will not independently develop similar technology.

WE MAY BECOME INVOLVED IN INTELLECTUAL PROPERTY DISPUTES AND CANNOT PREDICT THE
LIKELIHOOD OR IMPACT OF AN UNFAVORABLE OUTCOME.

We expect that as competition in the market for Internet filtering
increases and as the number of patents continues to increase, the potential for
intellectual property claims against us may also increase. Prolonged
13
<PAGE> 15

litigation against us concerning alleged infringement would likely result in
significant expense to us and divert the efforts of our management and
development personnel, even if we are successful in that litigation. 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 infringing technology,

- obtain a license for the technology or expend significant resources to
develop noninfringing technology, and

- attempt to redesign our filtering services to avoid the infringement or
to develop noninfringing technology.

Any limitation on our ability to market our services or products or any
incurrence of substantial costs and delays associated with redesigning our
services or products would seriously harm our business, financial condition, and
results of operations.

OUR SERVICES CREATE RISKS OF POTENTIAL NEGATIVE PUBLICITY AND LEGAL LIABILITY.

Because customers rely on our services for providing a content safe
Internet environment, any significant defects or errors in our services or
products may result in negative publicity or legal claims. This negative
publicity or any of these legal claims could seriously harm our business,
financial condition and results of operations. In addition, our ability to
maintain a log of Internet data retrieval requests and the workstations from
which they originated may result in negative publicity or claims based on
potential privacy violations. 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 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.

In August 1998, we entered into an Internet hosting agreement with Exodus
Communications, Inc., which will maintain some of our servers through August
1999, with automatic one year renewals. Our operations depend on Exodus's
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
diminish revenues, decrease customer and user confidence in our services and/or
stunt the growth of our business.

WE MAY NOT BE ABLE TO DISTRIBUTE OUR SERVICES ABROAD DUE TO UNITED STATES EXPORT
LAWS.

The encryption technology contained in our services and products is subject
to United States export controls. Such 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 exportation
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.

14
<PAGE> 16

THE FUTURE ROLE OF THE INTERNET IN EDUCATION IS UNCERTAIN.

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. 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. 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 use of the Internet experiences a significant
decline, we may not be successful in growing our business and our financial
condition and results of operations would be seriously harmed.

GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES COULD ADD ADDITIONAL COSTS TO
DOING BUSINESS ON THE INTERNET.

Currently, few laws or regulations specifically govern communications or
commerce on the Internet. In the future, laws and regulations may be adopted
regarding user privacy, pricing, and the characteristics and quality of products
and services. For example, the Telecommunications Act of 1996 sought to prohibit
transmitting various types of information and content over the Internet. Several
telecommunications companies have petitioned the Federal Communications
Commission to regulate Internet service providers and online service providers
in a manner similar to long distance telephone carriers and to impose access
fees on those companies. This could increase the cost of transmitting data over
the Internet.

WE MAY BE SUED FOR INFORMATION RETRIEVED FROM THE WEB.

We may be subject to claims relating to information available on our Web
site. These types of claims have been brought, sometimes successfully, against
online services. We could also be subject to claims based upon the content that
is accessible from our Web sites through links to other Web sites or through
content and materials that may be posted by members in chat rooms or bulletin
boards. We also offer e-mail services, which may subject us to liabilities
resulting from unsolicited e-mail, lost or misdirected messages, illegal or
fraudulent use of e-mail or interruptions or delays in e-mail service. Our
general commercial liability insurance may not adequately protect us against
these types of potential claims.

OUR STOCK PRICE WILL BE VOLATILE.

The market price of our common stock has been and is likely to continue to
be highly volatile and could be subject to wide fluctuations in response to:

- quarterly variations in operating results,

- announcements of technological innovations or new services or products by
us or our competitors,

- changes in financial estimates by securities analysts,

- our failure to meet or exceed analyst estimates, and

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

In addition, the stock market has experienced significant price and volume
fluctuations that have particularly affected the market prices of equity
securities of many Internet companies and that often have been unrelated or
disproportionate to the operating performance of these companies. A number of
publicly traded technology companies have current market prices below their
initial public offering price. Market fluctuations such as these may seriously
harm the market price of our common stock. In the past, following periods of
volatility in the marketplace for a company's securities, securities class
action litigation often has been instituted. We would incur substantial costs
and a diversion of management attention and resources resulting from such
litigation, which would seriously harm our business, financial condition, and
results of operations.
15
<PAGE> 17

OUR OFFICERS, DIRECTORS AND SIGNIFICANT SHAREHOLDERS HAVE VOTING CONTROL.

As of September 30, 2000, 54% of our outstanding common stock was
beneficially owned by our directors, executive officers and each person or group
that we know owns more than 5% of our common stock, together with the
individuals or entities affiliated with them, assuming no exercise of
outstanding warrants or stock options. These shareholders, if acting together,
are able to control substantially all matters requiring approval by our
shareholders, including the election of all directors and approval of
significant corporate transactions.

WE MAY NEED ADDITIONAL CAPITAL AND MAY BE UNABLE TO RAISE IT ON ACCEPTABLE
TERMS.

We may experience a material decrease in liquidity due to increased
operating expenses, unforeseen capital requirements or other events and
uncertainties. After that, we may need to raise additional funds, and additional
financing may not be available on favorable terms, if at all. 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. If we cannot
raise funds on acceptable terms, we may not be able to develop or enhance our
services, take advantage of future opportunities or respond to competitive
pressures or unanticipated requirements. This may seriously harm our business
and results of operations.

WE HAVE IMPLEMENTED ANTI-TAKEOVER PROVISIONS.

Some provisions of our Restated Articles of Incorporation and Amended
Bylaws, as well as provisions of Washington law, make it more difficult for a
third party to acquire us, even if doing so would be beneficial to our
shareholders.

WE DO NOT INTEND TO PAY DIVIDENDS.

We have never declared or paid any cash dividends on our common stock. We
currently intend to retain any future earnings for funding growth and,
therefore, do not expect to pay any dividends in the foreseeable future.

ITEM 2. PROPERTIES.

Our principal place of business is located in Seattle, Washington where, as
of September 30, 2000, we lease approximately 56,000 square feet of office
space. Beginning October 15, 2000 we amended our lease agreement to decrease our
total leased space to approximately 43,000 square feet. Our principal lease
expires on August 31, 2005. Subsidiary offices in Australia and the United
Kingdom are located in leased facilities under leases expiring in August 31,
2003, and April 30, 2003, respectively. We believe that these facilities are
adequate to meet our current needs and that suitable additional or alternative
space will be available as needed in the future on commercially reasonable
terms. See Note 6 of "Notes to Consolidated Financial Statements."

ITEM 3. LEGAL PROCEEDINGS.

At this time, there are no material pending legal proceedings.

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

No matters were submitted to a vote of security holders during the fourth
quarter ended September 30, 2000.

16
<PAGE> 18

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS.

Our Common Stock is traded on the Nasdaq National Market under the symbol
"NTWO." The following table sets forth the high and low closing prices as
reported by Nasdaq for the Common Stock of the Company since the initial public
offering for the quarters ended as follows. Such quotations represent inter-
dealer prices without retail markup, markdown or commission and may not
necessarily represent actual transactions.

<TABLE>
<CAPTION>
HIGH LOW
------- -------
<S> <C> <C>
FISCAL 2000
Fourth Quarter of 2000 -- July 1, 2000 through September
30, 2000............................................... 5.2344 1.875
Third Quarter of 2000 -- April 1, 2000 through June 30,
2000................................................... 13.50 3.50
Second Quarter of 2000 -- January 1, 2000 through March
31, 2000............................................... 25.0938 11.0625
First Quarter of 2000 -- October 1, 1999 through December
31, 1999............................................... 33.125 7.875
FISCAL 1999
Fourth Quarter of 1999 -- July 30, 1999 through September
30, 1999............................................... 13.50 7.125
</TABLE>

During the fiscal year of 2000, we continued to use proceeds from the
initial public offering dated July 30, 1999. To date, offering proceeds have
been used for working capital and other general corporate purposes.

The remaining net proceeds have been invested in cash equivalents and
short-term securities. The use of proceeds from the offering does not represent
a material change in the use of proceeds described in the prospectus included as
part of the Registration Statement.

As of November 29, 2000, there were approximately 206 registered holders of
the Company's Common Stock which number does not include the number of
shareholders whose shares are held of record by a brokerage house or clearing
agency but does include such brokerage house or clearing agency as one record
holder. We believe that we have over 5,500 shareholders.

We have never declared or paid any cash dividends on our capital stock. We
currently intend to retain any future earnings to finance the growth and
development of our business and therefore do not anticipate paying any cash
dividends in the foreseeable future.

ITEM 6. SELECTED FINANCIAL DATA.

The following selected consolidated financial data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations," our Consolidated Financial Statements and Notes
thereto and other financial information included elsewhere in this annual
report.

<TABLE>
<CAPTION>
FISCAL YEAR ENDED SEPTEMBER 30,
--------------------------------------------------
1996 1997 1998 1999 2000(1)
------ ------ ------- ------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues.................................. $ 108 $1,118 $ 3,078 $ 6,680 $ 10,973
Loss from operations...................... (817) (762) (2,310) (7,869) (41,297)
Interest income (expense), net............ (10) (119) (287) 148 2,039
Net loss.................................. (827) (881) (2,597) (7,721) (39,258)
Basic and diluted net loss per share...... $(0.11) $(0.10) $ (0.30) $ (0.57) $ (1.82)
Basic and diluted weighted average shares
outstanding............................. 7,317 8,390 8,687 13,620 21,578
</TABLE>

17
<PAGE> 19

<TABLE>
<CAPTION>
FISCAL YEAR ENDED SEPTEMBER 30,
-------------------------------------------------
1996 1997 1998 1999 2000
----- ------- ------- ------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash....................................... $ 128 $ 71 $ 121 $ 7,743 $ 7,993
Working capital (deficit).................. 27 (829) (2,234) 41,447 22,445
Property and equipment, net................ 163 453 1,271 3,990 10,192
Total assets............................... 400 784 1,848 67,556 44,111
Long-term obligations, excluding current
portion(2)............................... 544 826 1,942 1,255 3,482
Total shareholders' equity (deficit)....... (352) (1,201) (2,904) 61,498 34,559
</TABLE>

---------------
(1) Includes the impact of a $6,089,000 write-down on acquired intangible assets
that reduced basic and diluted earnings per share by $0.28 for the year and
the results of operations of iseek, Ltd. since its acquisition on February
23, 2000.

(2) Includes deferred revenue and capital lease obligations.

18
<PAGE> 20

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT
OF OPERATIONS.

You should read this section together with the financial statements and
other financial information included in this Form 10-K. This discussion contains
forward-looking statements that involve risks and uncertainties. Our actual
results may differ materially from those indicated in these forward-looking
statements. Certain reclassifications of prior year balances have been made for
consistent presentation with the current year.

OVERVIEW

N2H2 is a leading Internet management company, providing filtering,
reporting and usage management software, and related professional services that
conserve bandwidth, increase user productivity, and seek to limit potential
legal liability. Our internet filtering is designed to enable large scale
organizations (enterprises, government institutions, Internet Service Providers
(ISPs), schools) to control costs through customizable filtering levels that are
designed to allow access to only the Web content most relevant to their specific
environment.

As a leading provider of Internet content filtering to schools, N2H2 is
attempting to leverage its expertise in filtering large-scale networks within
sensitive environments via additional channel presence and/or expansion plans
for ISP's, corporations, governments, and other organizations. For the fiscal
year ended September 30, 2000, we covered approximately 16.1 million users
worldwide who accessed approximately 4.0 billion page views over the year.
Additionally, we have placed more than 1,800 servers in 11 countries including
the US, Canada, Australia, Japan, the United Kingdom, Germany, Switzerland,
Korea, Chile, Mexico, and China. To cover these markets, we use a combination of
our own sales force and various resellers both domestic and international.

Since inception, we have derived most of our revenues through a combination
of subscription and installation fees from our Internet services. Customers
generally pay a one-time installation fee and enter into a subscription
contract, which is typically 12 months in duration. Through fiscal 2000, we
recognized installation revenues upon installation of our servers. As a result
of the Company's adoption of Staff Accounting Bulletin No. 101 ("SAB 101") on
October 1, 2000, installation fees will be recognized over the expected period
of the customer relationship. Subscription revenues will continue to be
recognized on a monthly basis over the life of the subscription contract.

During 1999, we began to offer alternate fee structures to our school
customers. We gave them the choice of paying our recurring subscription fees or
receiving our filtering services at reduced rates or without charge in exchange
for allowing us to sell sponsorship rights to advertisers and to make
Searchopolis the default search engine on their networks. As noted in our Annual
Report on Form 10-K for fiscal 1999, we were unable to predict the impact of
this fee structure on our revenues. The revenues resulting from advertising and
sponsorships were less than hoped for. As a result, we are terminating the
advertising-based fee structure previously offered to schools. Customers
currently under this model will be converted to an alternative fee structure. We
will continue to provide filtering under the advertising-based model through the
end of the school year. The Company believes this move will create more
consistent long-term revenue, while still providing the best possible products
for our customers.

We are building products for the enterprise filtering market place. The
Company plans to release the public beta version of our filtering technology for
the new Microsoft Internet Security and Acceleration (ISA) Server 2000 to
initial customers in early 2001. A private beta testing was launched in December
2000. The Company expects to release its final version simultaneously with
Microsoft's release of ISA Server 2000, which is currently scheduled for first
quarter of calendar year 2001. Further product development is continuing, and we
anticipate launching eight to ten products compatible with widely accepted
platforms during calendar year 2001.

N2H2's Internet Filtering Manager, our new client-server hybrid solution
that was released in August 2000, has already been adopted by a number of small
Internet service providers worldwide. The product has been localized into
Spanish and Portuguese to meet the overseas interest in this product.

19
<PAGE> 21

We have a limited operating history and our prospects are subject to the
risks, expenses, and difficulties encountered by companies in the rapidly
evolving Internet market. We have incurred significant net losses since
inception and, as of September 30, 2000, had incurred aggregate operating losses
of approximately $51.3 million from inception. These losses have been funded
primarily through the issuance of common stock and debt. We intend to continue
to seek opportunities to improve efficiencies in our operations to better
control expenses.

Revenues: We generate our revenues primarily from installation and
subscription fees charged for our filtering services, consulting fees, and
advertising fees. Our increasing revenues over the period-to-period comparisons,
which follow, have been due primarily to increased sales volumes. Advertising
revenues will decrease in the future as we transition from the advertising to
the fee for service model in the education marketplace. Our implementation of
SAB 101, effective beginning in fiscal 2001, will result in installation
revenues being recognized over the life of the customer relationship.
Comparisons between fiscal 2001 and 2000 will show a slower growth rate of
revenues between these years as a result.

Internet filtering services and customer support costs: Costs of Internet
filtering services and customer support consists of the costs of Website review,
technical installation and support, search engine and Web hosting services, and
bandwidth.

Educational content and advertising costs: Educational content and
advertising expenses included product license fees and advertising commissions.
Some product licenses fees will be reduced in fiscal 2001 compared to fiscal
2000 due to the cancellation of certain contracts.

Sales and marketing: Sales expenses consist primarily of salaries,
commissions and bonuses. Marketing expenses consist primarily of salaries,
marketing brochures, trade shows, direct mailing programs, advertising, public
relations and travel. Sales and marketing expenses also include an allocation of
corporate facilities costs. We believe that sales and marketing costs will
decrease as a result of focusing our sales and marketing efforts more
specifically on clearly targeted markets and products.

Research and development: Research and development expenses 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 products and enhancing existing products.
Product costs related to internal research and development have been expensed as
incurred. Future research and development expenditures may be directed towards
development of enhancements of our filtering technologies, and other future
service enhancements not presently defined.

General and administrative: General and administrative expenses consist
primarily of salaries, benefits and related costs for our executive, finance,
human resources and administrative personnel, third-party professional service
fees, and allocation of our corporate facilities costs. Ongoing general and
administrative expenses will reflect recent efficiencies in our operations. At
the close of fiscal year 2000, we increased productivity and reduced costs
through substantial reductions in staff and expenses. We are continuing to
aggressively pursue productivity increases and cost-cutting initiatives.

Income Taxes: Prior to May 1999 we were an S corporation for federal income
tax purposes, and effective May 11, 1999, became a C corporation. As a C
corporation, we are subject to income tax at the corporate level to the extent
we have generated net income. Any operating losses we incur will result in net
operating loss carry-forwards potentially available to offset future taxable
income. A full valuation allowance has currently been recorded against any
deferred tax assets available to us for use in future periods because
realization of these assets is primarily dependent on generating taxable net
income in the future.

In view of the rapidly changing nature of our business and our limited
operating history, we believe that period-to-period comparisons of revenues and
operating results are not necessarily meaningful. You should not rely upon this
information as an indication of future performance.

20
<PAGE> 22

FISCAL YEAR ENDED SEPTEMBER 30, 2000 COMPARED TO FISCAL YEAR ENDED SEPTEMBER 30,
1999

Internet filtering and consulting service revenues: Internet filtering and
consulting service revenues accounted for 78% of the revenues for fiscal 2000.
Internet filtering and consulting service revenues increased $3.0 million, or
53%, to $8.6 million for fiscal 2000, from $5.6 million for fiscal 1999. The
increase reflects the growth in proxy server installations and filtering
subscriptions, as the number of filtering customers increased from 8.1 million
in fiscal 1999 to 16.1 million in fiscal 2000. The introduction of consulting
services in fiscal 2000 also contributed to the increase in revenues.

Advertising revenues: Advertising revenues accounted for 22% of total
revenues for fiscal 2000, compared to 16% for fiscal 1999. Advertising revenues
increased by $1.3 million, or 118%, to $2.4 million for fiscal 2000, from $1.1
million for fiscal year 1999. The increase resulted from the official launch of
the advertising fee model in late fiscal 1999, which led to increased
sponsorship contracts and a higher volume of ads placed. We expect that
advertising revenues will decrease in future periods as N2H2 transitions back to
a subscription fee-based model for all customers.

Internet filtering services and customer support: Costs of Internet
filtering services and customer support increased by $3.9 million, or 139%, to
$6.7 million for fiscal 2000 from $2.8 million for fiscal 1999. This increase
was primarily due to the hiring of additional customer operations personnel to
provide more technical support and service to our expanded customer bases.

Educational content and advertising costs: Educational content and
advertising expenses increased by $1.2 million, or 365%, to $1.5 million for
fiscal 2000, from $0.3 million for fiscal 1999. This increase was primarily due
to software license contracts entered into during the year and advertising
commissions. In addition, in fiscal 1999, N2H2 switched many customers from fee
for service to the ad model. This resulted in a full year of advertising serving
costs in fiscal 2000 compared to a partial year in fiscal 1999.

Sales and marketing: Sales and marketing expenses increased by $11.8
million, or 303%, to $15.7 million for fiscal 2000, from $3.9 million for fiscal
1999. This increase was primarily due to the hiring of additional sales and
marketing personnel during the year to expand our market position including an
aggressive expansion internationally. In addition, costs were incurred in fiscal
2000 for general corporate brand awareness campaigns and the introduction of new
products.

Research and development: Research and development expenses increased by
$2.3 million, or 100%, to $4.6 million for fiscal 2000, from $2.3 million for
fiscal 1999. This increase was primarily due to an increase in the number and
cost of software developers and technical personnel supporting development of
our filtering and Searchopolis services. The increase reflected our ongoing R&D
efforts in a wide variety of new products, including the client server hybrid
solution and enterprise filtering line of products. We also purchased licensed
agreements for technology in order to bring products to the market in a timely
fashion. All of our R&D costs are expensed as incurred.

General and administrative: General and administrative expenses increased
by $5.5 million, or 167%, to $8.8 million for fiscal 2000, from $3.3 million for
fiscal 1999. This increase was primarily due to the addition of personnel to
support the growth of our business, notably in information technology, and the
severance-related costs for terminated officers.

Write-down of acquired intangible costs: Certain intangible assets related
to the acquisition of iseek Limited (iseek) in February 2000 were assessed for
impairment at September 30, 2000 due to operating results and forecasts from
iseek being less than expected. This assessment resulted in a write-down of
intangible assets of $6.1 million. As a result of this write-down, non-cash
amortization of goodwill has been completed in fiscal 2000. Further, management
expects that non-cash amortization will be significantly reduced in 2001 and
future years.

Amortization of deferred stock compensation: Amortization of deferred stock
compensation increased by $3.6 million, or 453%, to $4.4 million for fiscal
2000, from $0.8 million for fiscal 1999. As a result of the acquisition of iseek
in February 2000, N2H2 recorded deferred stock compensation of $8.9 million
related to

21
<PAGE> 23

the employment of certain executives of iseek. The deferred compensation is
being amortized over a three-year period.

FISCAL YEAR ENDED SEPTEMBER 30, 1999 COMPARED TO FISCAL YEAR ENDED SEPTEMBER 30,
1998

Internet filtering and consulting service revenues: Internet filtering and
consulting service revenues increased $2.5 million, or 81%, to $5.6 million for
fiscal 1999, from $3.1 million for fiscal 1998. The increase reflected the
growth in proxy server installations and filtering services provided to an
increased customer base.

Advertising revenues: Advertising revenues accounted for 16% of total
revenues for fiscal 1999, compared to 0% for fiscal 1998. Advertising revenues
were $1.1 million for fiscal 1999, from $0 for fiscal 1998, as we introduced our
advertising model and began selling advertising on our filtering services during
fiscal 1999.

Internet filtering services and customer support: Cost of Internet
filtering services and customer support increased by $1.7 million, or 146%, to
$2.8 million for fiscal 1999, from $1.1 million for fiscal 1998. The increase
was a result of an increased customer base to support.

Educational content and advertising costs: Educational content and
advertising cost represented 5% of total revenues for fiscal 1999, compared to
0% for fiscal 1998. Educational content and advertising expenses were $0.3
million for fiscal 1999, from $0 million for fiscal 1998, as we introduced our
advertising model and began selling advertising on our filtering services during
fiscal 1999.

Sales and marketing: Sales and marketing expenses increased by $2.2
million, or 129%, to $3.9 million for fiscal 1999, from $1.7 million for fiscal
1998. This increase was primarily due to the hiring of additional sales and
marketing personnel.

Research and development: Research and development expenses increased by
$1.8 million, or 367%, to $2.3 million for fiscal 1999, from $0.5 million for
fiscal 1998. This increase was primarily due to an increase in the number of
software developers and technical personnel supporting development of our
filtering services.

General and administrative: General and administrative expenses increased
by $1.6 million, or 92%, to $3.3 million for fiscal 1999, from $1.7 million for
fiscal 1998. This increase was primarily due to the hiring of additional
personnel to support the growth of our business.

Amortization of deferred stock compensation: Amortization of deferred stock
compensation expenses was $0.8 million for fiscal 1999 as a result of N2H2
recording deferred compensation expenses for employee stock options at prices
subsequently deemed to be lower than fair market value. There was no such
expense for fiscal 1998.

LIQUIDITY AND CAPITAL RESOURCES

Since inception, we have funded our operations primarily through private
sales of equity securities, the use of short-term and long-term debt, and
capital leases. As of September 30, 2000, we had cash and cash equivalents of
$8.0 million, and short term investments of $17.2 million. Our operating
activities resulted in net cash outflows of $24.8 million for the year ended
September 30, 2000, an outflow of $6.0 million for the year ended September 30,
1999, and an inflow of $0.3 million in 1998. The operating cash outflow in
fiscal 2000 resulted principally from net operating losses. The operating cash
outflow in fiscal 1999 resulted from net operating losses, increases in accounts
receivable and prepaid expenses, and other assets. The operating cash inflow in
fiscal 1998 resulted primarily from increases in prepayment of subscription
fees, accounts payable, and accrued liabilities.

Capital expenditures, excluding those under capital leases, totaled $9.5
million in fiscal 2000, $2.2 million in fiscal 1999, and $0.4 million in fiscal
1998. We anticipate that our overall capital expenditure rate will decrease in
future years. While we will continue to experience an increase in capital
expenditures consistent with our anticipated growth in sales and installations
of new proxy servers, we believe that our current internal infrastructure is
adequate to support additional growth. We anticipate that minimal purchases of
equipment will be required to support our internal operations, administrative
infrastructure, and personnel in fiscal 2001.
22
<PAGE> 24

Investment activities resulted in a net cash inflow of $20.8 million in
fiscal 2000. This was the result of maturing of investments offset by the
purchases of investments and the additions to property and equipment. Investment
activities resulted in a cash outflow of $54.9 million in fiscal 1999. This was
the result of investing the proceeds of our initial public offering.

Financing activities for fiscal 2000 resulted in a net cash inflow of $4.3
million, primarily consisting of borrowings of $5.0 million under notes payable.
For fiscal 1999, cash provided by financing activities resulted in a cash inflow
of $68.5 million, which consisted primarily of $69.2 million received in
connection with the sale of common stock and warrants including our initial
public offering of common stock. Other financing activities in fiscal 1999
consisted of $2.0 million of proceeds from long-term debt borrowings less $1.8
million of repayments and $1.1 million of payments made under capital lease
obligations. Our financing activities provided $147,000 in 1998, which consisted
primarily of $210,000 in proceeds from long-term borrowings, reduced by $63,000
in payments on capital lease obligations and repayments of notes payable.

On April 6, 2000, we drew a $2.0 million equipment advance from our term
loan with Imperial Bank. The advance is collateralized by a first priority
security interest in all of our unpledged assets. Borrowings under this facility
are payable in thirty-six equal monthly installments of principal plus accrued
interest. Interest is accrued at the bank's prime rate plus 1.0%.

On September 20, 2000, we amended and restated our term loan and line of
credit facilities with Imperial Bank. Under the amended and restated agreement,
we drew an additional equipment advance for $3.0 million on September 29, 2000.
The advance is collateralized by a first priority security interest in all of
our unpledged assets. Borrowings under this facility are payable in thirty-six
monthly installments of principal plus accrued interest. Interest is accrued at
the bank's prime rate plus 1.0%. The amended and restated agreement also
provides for a revolving line of credit for draws of 80% of accounts receivable
assigned as security up to a maximum short-term borrowing of $2.5 million, if
specified conditions are met. Our available borrowings under the line of credit
are reduced by an irrevocable standby letter of credit in the amount of
$715,000, which expires on July 31, 2005. Advances on the revolving line of
credit bear interest on the outstanding daily balance at a rate of 0.5% above
the bank's prime rate.

Operating expenses, together with capital expenditures related to filtering
servers, will consume a significant amount of our cash resources. We intend to
reduce our operating expenses in fiscal 2001 and beyond as we streamline
operations while entering new markets with our services and further develop our
sales channels and international presence. We believe that our cash and
short-term investments on hand, together with cash from operations, will be
sufficient to meet our anticipated cash needs for at least the next 12 months.
If cash generated from operations is insufficient to satisfy our longer-term
liquidity requirements, we may seek to sell additional equity or debt securities
or to obtain a larger credit facility. 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. See "Risk Factors -- We May Need
Additional Capital And May Be Unable To Raise It On Acceptable Terms" for a
description of risks associated with a decrease in liquidity.

RECENTLY ISSUED ACCOUNTING STANDARDS

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities." This statement requires that all derivative instruments
be recorded on the balance sheet at their fair value. Changes in the fair value
of derivatives are recorded each period in current earnings or other
comprehensive income, depending on whether a derivative is designated as part of
a hedge transaction and, if it is, the type of hedge transaction. In July 1999,
the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging
Activities Deferral of the Effective Date of FASB Statement No. 133." SFAS No.
137 deferred the effective date of SFAS No. 133 until fiscal years beginning
after June 15, 2000. We do not use derivative instruments; therefore, the
adoption of this statement is not expected to have any effect on our results of
operations or our financial position.

23
<PAGE> 25

In December 1999, SEC Staff Accounting Bulletin: No. 101 -- Revenue
Recognition in Financial Statements (SAB 101) was issued. This pronouncement
requires, among other things, that recognition of certain nonrefundable up-front
fees be deferred and recognized generally over the term of the customer
relationship. SAB 101 is required to be adopted by the Company for the year
ended September 30, 2001. In fiscal 2000 and previous years, N2H2 recognized
installation revenue upon completion of the installation. Effective October 1,
2000, in accordance with the provisions of SAB 101, we will begin deferring
installation revenue over the expected life of the customer relationship.
Accordingly, the adoption of SAB 101 will result in a cumulative effect
adjustment for a change in accounting principle. The total cumulative effect of
the non-cash charge is estimated to be $3.6 million. Such amount will be
recorded as deferred revenue and recognized as installation revenue in future
periods.

ITEM 7A. 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 subsidiaries. We have not hedged our translation risk on
these assets and liabilities as we have the ability to hold them for an
indefinite period. 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 amounts of cash
equivalents, investments, notes payable and capital lease obligations at
September 30, 2000 are reasonable approximations of their fair values. As a
result, we believe that the market risk arising from our holdings of financial
instruments is minimal.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Accountants........................... 25
Consolidated Balance Sheets as of September 30, 2000 and
1999...................................................... 26
Consolidated Statements of Operations for the Fiscal Years
Ended September 30, 2000, 1999 and 1998................... 27
Consolidated Statements of Changes in Shareholders' Equity
(Deficit) for the Fiscal Years Ended September 30, 2000,
1999 and 1998............................................. 28
Consolidated Statements of Cash Flows for the Fiscal Years
Ended September 30, 2000, 1999 and 1998................... 29
Consolidated Notes to Financial Statements.................. 30
</TABLE>

24
<PAGE> 26

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors
and Shareholders of
N2H2, Inc.

In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) present fairly, in all material respects, the
financial position of N2H2, Inc. and its subsidiaries at September 30, 2000 and
1999, and the results of their operations and their cash flows for each of the
three years in the period ended September 30, 2000, in conformity with
accounting principles generally accepted in the United States of America. In
addition, in our opinion, the financial statement schedule listed in the index
appearing under Item 14(a)(2) presents fairly, in all material respects, the
information set forth therein when read in conjunction with the related
consolidated financial statements. These financial statements and financial
statement schedule are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements and the
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with auditing standards generally accepted in the
United States of America which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.

PricewaterhouseCoopers LLP

Seattle, Washington
December 20, 2000

25
<PAGE> 27

N2H2, INC.

CONSOLIDATED BALANCE SHEETS

ASSETS

<TABLE>
<CAPTION>
SEPTEMBER 30,
----------------------
2000 1999
--------- ---------
(IN THOUSANDS, EXCEPT
SHARE AMOUNTS)
<S> <C> <C>
Current assets
Cash and cash equivalents................................. $ 7,993 $ 7,743
Investments............................................... 17,292 35,937
Accounts receivable (net of allowances of $313 and $142 in
2000 and 1999, respectively)........................... 2,069 1,434
Prepaid expenses and other current assets................. 1,161 1,136
-------- --------
Total current assets.............................. 28,515 46,250
Long-term investments....................................... 3,000 16,698
Acquired intangible assets, net............................. 1,490 --
Property and equipment, net................................. 10,192 3,990
Other assets................................................ 914 618
-------- --------
Total assets...................................... $ 44,111 $ 67,556
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Accounts payable.......................................... $ 1,982 $ 1,871
Royalties payable......................................... 198 100
Accrued liabilities....................................... 1,277 1,062
Deferred revenue.......................................... 762 1,304
Current portion of capital lease obligations.............. 205 466
Current portion of long-term debt......................... 1,646 --
-------- --------
Total current liabilities......................... 6,070 4,803
Deferred revenue............................................ 184 303
Capital lease obligations, net of current portion........... 222 952
Long-term debt, net of current portion...................... 3,076 --
-------- --------
Total liabilities................................. 9,552 6,058
-------- --------
Commitments and contingencies (Notes 6 and 16)
Shareholders' equity
Preferred stock, no par value; 50,000,000 shares
authorized, no shares issued and outstanding........... -- --
Common stock, no par value; 250,000,000 shares authorized;
22,582,509 and 21,064,285 issued and outstanding in
2000 and 1999, respectively............................ 93,085 75,528
Notes receivable from shareholders........................ (1,073) (25)
Deferred stock compensation............................... (6,069) (1,940)
Accumulated other comprehensive loss...................... (61) --
Accumulated deficit....................................... (51,323) (12,065)
-------- --------
Total shareholders' equity........................ 34,559 61,498
-------- --------
Total liabilities and shareholders' equity........ $ 44,111 $ 67,556
======== ========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
26
<PAGE> 28

N2H2, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30,
----------------------------------------------------
2000 1999 1998
--------------- --------------- --------------
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C>
Revenues:
Internet filtering and consulting services......... $ 8,593 $ 5,605 $ 3,078
Advertising........................................ 2,380 1,075 --
----------- ----------- ----------
Total revenues............................. 10,973 6,680 3,078
Operating expenses:
Internet filtering services and customer support... 6,734 2,806 1,142
Educational content and advertising costs.......... 1,495 322 --
Sales and marketing (excludes amortization of stock
compensation of $3,287, $78 and $0 in 2000, 1999
and 1998, respectively)......................... 15,684 3,895 1,725
General and administrative (excludes amortization
of stock compensation of $890, $573, and $0 in
2000, 1999 and 1998, respectively).............. 8,762 3,267 1,703
Research and development (excludes amortization of
stock compensation of $207, $142, and $0 in
2000, 1999 and 1998, respectively).............. 4,610 2,310 495
Depreciation and amortization...................... 4,512 1,156 323
Write-down of acquired intangible assets........... 6,089 -- --
Amortization of deferred stock compensation........ 4,384 793 --
----------- ----------- ----------
Total operating expenses................... 52,270 14,549 5,388
----------- ----------- ----------
Loss from operations................................. (41,297) (7,869) (2,310)
Interest income (expense), net....................... 2,039 148 (287)
----------- ----------- ----------
Net loss............................................. $ (39,258) $ (7,721) $ (2,597)
=========== =========== ==========
Foreign currency translation loss.................. (61) -- --
----------- ----------- ----------
Comprehensive loss................................... $ (39,319) $ (7,721) $ (2,597)
=========== =========== ==========
Basic and diluted net loss per common share.......... $ (1.82) $ (0.57) $ (0.30)
=========== =========== ==========
Basic and diluted weighted average shares
outstanding........................................ 21,578,000 13,620,000 8,687,000
=========== =========== ==========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
27
<PAGE> 29

N2H2, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT)

<TABLE>
<CAPTION>
NOTE ACCUMULATED
COMMON STOCK RECEIVABLE DEFERRED OTHER
-------------------- FROM STOCK OPTION COMPENSATION ACCUMULATED
SHARES AMOUNT SHAREHOLDERS COMPENSATION INCOME DEFICIT TOTAL
---------- ------- ------------ ------------ ------------ ----------- --------
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at September 30, 1997........ 8,686,411 $ 546 $ -- $ -- $ -- $ (1,747) $ (1,201)
Exercise of stock options............ 374,062 75 75
Compensation expense recognized on
issuance of stock, stock options
and warrants....................... 819 819
Net loss............................. (2,597) (2,597)
---------- ------- ------- ------- ---- -------- --------
Balance at September 30, 1998........ 9,060,473 1,440 -- -- -- (4,344) (2,904)
Issuance of common stock, private
offering, net of issuance costs of
$243............................... 4,131,245 10,788 10,788
Issuance of common stock, public
offering, net of issuance costs of
$1,409............................. 4,950,000 58,436 58,436
Exercise of warrants................. 6,342 20 20
Issuance of warrants................. 77 77
Conversion of notes payable into
common stock....................... 1,998,622 1,693 1,693
Exercise of stock options............ 792,603 156 (25) 131
Compensation expense recognized on
issuance of common stock........... 125,000 216 216
Deferred compensation expense
relating to issuance of stock
options............................ 2,702 (2,702) --
Amortization of deferred stock option
compensation....................... 762 762
Net loss............................. (7,721) (7,721)
---------- ------- ------- ------- ---- -------- --------
Balance at September 30, 1999........ 21,064,285 75,528 (25) (1,940) -- (12,065) 61,498
Issuance of common stock related to
acquisition, net of purchase
costs.............................. 925,000 16,104 (8,911) 7,193
Issuance of common stock related to
employee stock purchase plan....... 36,453 77 77
Exercise of stock options and
warrants........................... 556,771 519 519
Issuance of warrants................. 1,255 1,255
Issuance of notes receivable to
shareholders, net of reserve of
$805............................... (1,048) (1,048)
Deferred compensation relating to
repricing of stock options......... 56 (56) --
Reversal of deferred compensation
relating to forfeiture of stock
options............................ (454) 454 --
Amortization of deferred stock option
compensation....................... 4,384 4,384
Comprehensive loss:
Net loss........................... (39,258) (39,258)
Unrealized loss on foreign
currency translation........... (61) (61)
---- -------- --------
Total comprehensive loss......... (61) (39,258) (39,319)
---------- ------- ------- ------- ---- -------- --------
Balance at September 30, 2000........ 22,582,509 $93,085 $(1,073) $(6,069) $(61) $(51,323) $ 34,559
========== ======= ======= ======= ==== ======== ========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
28
<PAGE> 30

N2H2, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30,
-------------------------------
2000 1999 1998
-------- -------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss.................................................... $(39,258) $ (7,721) $(2,597)
Adjustments to reconcile net loss to net cash provided by
(used by) operating activities:
Depreciation and amortization.......................... 4,512 1,262 346
Write-down of acquired intangible assets............... 6,089 -- --
Amortization of deferred stock compensation............ 4,384 762 --
Compensation expense on common stock and warrants...... -- 216 819
Provision for accounts receivable...................... 369 261 8
Provision for shareholder loans........................ 805 -- --
Notes payable issued for services...................... -- -- 98
Debt forgiven.......................................... -- (18) --
Change in certain assets and liabilities:
Accounts receivable.................................... (1,005) (1,374) (70)
Prepaid expenses and other assets...................... (384) (1,619) (134)
Accounts payable....................................... 57 1,420 372
Royalties payable...................................... 98 (50) 150
Accrued liabilities.................................... 215 601 364
Deferred revenue....................................... (661) 273 930
-------- -------- -------
Net cash (used by) provided by operating
activities...................................... (24,779) (5,987) 286
-------- -------- -------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of investments.................................. (13,000) (53,636) --
Maturities of investments................................. 45,344 1,001 --
Additions to property and equipment....................... (9,499) (2,240) (383)
Notes receivable from shareholders........................ (1,853) -- --
Transaction costs incurred for iseek, Ltd. acquisition,
net of cash acquired................................... (229) -- --
-------- -------- -------
Net cash used by investing activities............. 20,763 (54,875) (383)
-------- -------- -------
CASH FLOWS FROM FINANCING ACTIVITIES
Issuance of common stock, net............................. 77 69,224 --
Exercise of stock options and warrants.................... 519 151
Payments under capital lease obligations.................. (991) (1,128) (51)
Borrowings under notes payable............................ 5,000 2,000 210
Repayments of notes payable............................... (278) (1,763) (12)
-------- -------- -------
Net cash provided by financing activities......... 4,327 68,484 147
-------- -------- -------
Effects of exchange rates................................. (61) -- --
Net increase (decrease) in cash and cash equivalents........ 250 7,622 50
Cash and cash equivalents, beginning of period.............. 7,743 121 71
-------- -------- -------
Cash and cash equivalents, end of period.................... $ 7,993 $ 7,743 $ 121
======== ======== =======
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
29
<PAGE> 31

N2H2, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2000, 1999, AND 1998

1. DESCRIPTION OF BUSINESS

N2H2, Inc. (N2H2 or the Company), a Washington corporation, was founded in
1995. The Company is an Internet management company, providing filtering,
reporting and usage management software and related professional services to
conserve bandwidth, increase user productivity, and seeks to limit potential
legal liability. The Company's internet filtering is designed to enable large
scale organizations (enterprises, government institutions, ISPs, schools) to
control costs through customizable filtering levels that are designed to allow
users only access to Web content most relevant to their specific environment.

The Company has experienced significant net operating losses from
inception. In fiscal 2000, the Company incurred operating losses of $41.3
million and used $24.8 million of cash its operating activities. Management
expects that operating losses and negative cash flows to continue at least
through fiscal 2001 as the Company continues to develop its product offerings
and customer base. Management has, however, implemented reductions in force and
other cost reduction measures in fiscal 2001 to reduce future cash outflows. If
the Company fails to develop revenues from new products and expand its customer
base, it will require additional debt or equity financing to continue its
operations beyond September 30, 2001. Such financing may not be available on
acceptable terms or at all.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

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

Foreign Currency Translation

The functional currency of the Company's foreign operations is considered
to be the local currency. Financial statements of foreign subsidiaries are
translated into U.S. dollars using the exchange rate at each balance sheet date
for assets and liabilities and a weighted average exchange rate for each period
for revenues and expenses. Resulting translation adjustments are excluded from
results of operations and reported in accumulated other comprehensive income
(loss).

Cash and Cash Equivalents

Cash and cash equivalents represent funds on deposit with banks or invested
in a variety of highly liquid short-term instruments with original maturities of
less than three months.

Investments

The Company's investments are comprised primarily of debt securities, which
are classified as held-to-maturity at purchase. Investments with remaining
maturities of less than twelve months from the balance sheet date are classified
as short-term investments. Investments with remaining maturities of more than
twelve months are classified as long-term investments. For the purpose of
computing realized gains and losses, costs are identified on a specific
identification basis.

The cost method is used to account for the Company's investment in 4.8% of
the common stock of OneName/Intermind, a privately held company, because the
Company does not have the ability to exercise significant influence over
OneName/Intermind's operating and financial policies.

30
<PAGE> 32
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

Transfer of Financial Instruments

In the fiscal year ended September 30, 1999, the Company terminated the
practice of factoring accounts receivable with the bank. Prior to that, the
Company did factor certain customer receivables with full recourse to a bank.
The transfer of accounts receivable was recorded by the Company as a sales
transaction under the provisions of Statement of Financial Accounting Standards
(SFAS) No. 125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities. The receivables were sold at a discount which
was recorded upon sale, and monthly finance charges were incurred based upon
average monthly balances outstanding with the factor. These monthly fees were
recorded in the period incurred. Customer accounts repurchased from the factor
were included in accounts receivable.

Property and Equipment

Property and equipment are carried at cost less accumulated depreciation.
The Company depreciates property and equipment using the straight-line method
over the estimated useful lives of three to five years. Leasehold improvements
are amortized using the straight-line method over the shorter of the life of the
related asset or the term of the lease. Software developed or obtained for
internal use is capitalized and amortized over three years.

The cost of normal maintenance and repairs are charged to expense as
incurred. Expenditures for major improvements are capitalized, at cost. Gains or
losses on the disposition of assets are reflected in the results of operations
at the time of disposal.

Acquired Intangible Assets

Acquired intangible assets consist of developed technology, covenants not
to compete and customer lists purchased in conjunction with the iseek. Acquired
intangible assets are being amortized over five years, using the straight-line
method. The carrying value of acquired intangible assets is reviewed for
impairment periodically when circumstances indicate potential impairment. As a
result of such a review, the carrying value of intangible assets was written
down by approximately $6.1 million in fiscal 2000 (Note 7). Amortization expense
for fiscal year 2000 amounted to $1.0 million. There were no acquired intangible
assets or related amortization in the prior year.

Impairment of Long-lived Assets

The Company evaluates its long-lived assets for impairment and continues to
evaluate them as events or changes in circumstances indicate that the carrying
amount of such assets may not be fully recoverable. The Company evaluates the
recoverability of long-lived assets by measuring the carrying amount of the
assets against the estimated undiscounted future cash flows associated with
these assets. At the time such evaluations indicate that the future undiscounted
cash flows of certain long-lived assets are not sufficient to recover the
carrying value of such assets, the assets are adjusted to their fair values.
Fair value is determined using the expected net discounted cash flow from the
assets.

Royalties Payable

Royalties payable represent amounts payable to independent providers of
educational content and Internet search services under service agreements.
Amortization is based on the greater of amounts determined by the contractual
royalty rates or amounts computed on a straight-line basis over the terms of the
agreements.

31
<PAGE> 33
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

Revenue Recognition

The Company's revenues are derived from its filtering, Internet management,
and content delivery services. These primarily include filtering subscriptions,
installation fees and advertising revenue.

Subscription revenues represent the fees associated with the right to use
the Company's software and hardware, access to filtering updates and customer
support. Subscription revenues are recognized over the life of the subscription
contract. Subscription payments received in advance of revenue recognition are
recorded as deferred revenue.

Installation revenues represent fees associated with the customization and
installation of the Company's software on the proxy servers which are sent to
the customers. Installation revenues are recognized when the server is installed
by the end-user, and when the criteria for revenue recognition under Statement
of Position No. 97-2, Software Revenue Recognition, are applied and satisfied.
The criteria include, but are not limited to, the existence of vendor-specific
objective evidence, delivery of the service to a customer, the Company's lack of
significant obligations to the customer, and a determination that collectibility
of the amount due is probable.

Advertising revenue contracts based on the number of impressions displayed
or click-throughs provided are recognized as services are rendered.

Also included in revenues are barter revenues generated from exchanging
advertising services for a license. Revenues from barter transactions are
recognized at the fair market value of advertisements delivered in the period
when advertising is provided, and services received are charged to expense on a
straight-line basis over the contract period. Barter revenues for fiscal year
2000 were $0.6 million. There were no barter revenues in prior years.

Research and Development Costs

Research and development expenses consist principally of payroll and
related expenses for design and development of the Company's technologies.
Research and development costs related to these activities are expensed as
incurred.

Advertising and Marketing Expense

All costs related to marketing and advertising the Company's products are
expensed in the periods incurred. Advertising and marketing expenses were
$4,248,000, $1,145,000, and $120,000 for the years ended September 30, 2000,
1999 and 1998, respectively.

Federal Income Taxes

Prior to May 1999, the Company was an S corporation for federal income tax
purposes. Effective May 11, 1999, the Company became a C corporation and began
accounting for income taxes under the liability method of accounting. Under the
liability method, deferred income taxes are determined based on the difference
between the financial statement and tax bases of assets and liabilities at
enacted tax rates in effect in the year in which the differences are expected to
reverse. Valuation allowances are established, when necessary, to reduce
deferred tax assets to amounts expected to be realized.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentration
of credit risk include primarily cash and cash equivalents and accounts
receivable. The Company places its cash deposits and certain short-term
investments in bank deposits and money market funds with high credit quality
financial institutions. At September 30, 2000, the Company had cash in one
financial institution that exceeded federally

32
<PAGE> 34
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

insured limits. Domestic accounts receivable consists of account balances due
from customers dispersed across the United States with industry concentrations
in public institutions such as school districts and state and local governments.
International accounts receivable represent 25%, 7% and 3% of total accounts
receivable at September 30, 2000, 1999 and 1998, respectively, and are
denominated primarily in United States dollars.

No customer accounted for 10% or more of the Company's revenues in any
year.

Fair Value Disclosures

Recorded amounts of cash and cash equivalents, receivables, accounts
payable and other amounts included in current liabilities meeting the definition
of financial instruments approximate fair value based on the short-term maturity
of those instruments. The carrying value of long-term debt and capital lease
obligations are based on interest rates currently available to the Company and,
accordingly, approximates fair values. The carrying value of investments held
exceeded market value by $35,000 and $152,000 at September 30, 2000 and 1999,
respectively (Note 3).

Stock-Based Compensation

The Company applies the provisions of APB Opinion No. 25 (APB 25) for
transactions with employees and provides pro forma disclosures for employee
stock option grants as required by Statement of Financial Accounting Standards
(SFAS) No. 123.

Net Loss per Share

Basic loss per share is calculated as losses available to common
shareholders divided by the weighted-average number of common shares outstanding
during the periods. Diluted loss per share is based on the weighted-average
number of shares of common stock and common stock equivalents outstanding during
the periods, including options and warrants computed using the treasury stock
method. Basic and diluted net loss per share are equal for all periods presented
because the impact of common stock equivalents is anti-dilutive.

Business Segments

The Company maintains single sales, marketing, research and development and
administrative functions for all of its services and geographic regions.
Management uses one measurement of profitability and does not disaggregate its
business for internal reporting. Based on the criteria of SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information," the
Company has determined that it operates in one segment providing integrated
Internet management solutions.

Recently Issued Accounting Standards

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities." This statement requires that all derivative instruments
be recorded on the balance sheet at their fair value. Changes in the fair value
of derivatives are recorded each period in current earnings or other
comprehensive income, depending on whether a derivative is designated as part of
a hedge transactions and, if it is, the type of hedge transaction. In July 1999,
the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging
Activities Deferral of the Effective Date of FASB Statement No. 133." SFAS No.
137 deferred the effective date of SFAS No. 133 until fiscal years beginning
after June 15, 2000. The Company does not use derivative instruments; therefore,
the adoption of this statement is not expected to have any effect on the
Company's results of operations or its financial position.

33
<PAGE> 35
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

In December 1999, SEC Staff Accounting Bulletin: No. 101 -- Revenue
Recognition in Financial Statements (SAB 101) was issued. This pronouncement
requires, among other things, that recognition of certain nonrefundable up-front
fees be deferred and recognized generally over the term of the customer
relationship. SAB 101 is required to be adopted by the Company for the year
ended September 30, 2001. In fiscal 2000 and previous years, the Company
recognized installation revenue upon completion of the installation. Effective
October 1, 2000, in accordance with the provisions of SAB 101, the Company will
begin deferring installation revenue over the expected life of the customer
relationship. Accordingly, the adoption of SAB 101 will result in a cumulative
effect adjustment for a change in accounting principle. The total cumulative
effect of the non-cash charge is estimated to be $3.6 million. Such amount will
be recorded as deferred revenue and recognized as installation revenue in future
periods.

Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles 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.

Reclassifications

Certain reclassifications of prior year balances have been made for
consistent presentation with the current year.

3. INVESTMENTS

The Company's investment portfolio includes held-to-maturity securities.
The following table summarizes the composition of the Company's held-to-maturity
investments at September 30, 2000.

<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED AGGREGATE
COST BASIS GAINS LOSSES FAIR VALUE
----------- ---------- ---------- -----------
<S> <C> <C> <C> <C>
2000
U.S. Corporate Debt Securities... $ 7,305,000 $ $ (20,000) $ 7,285,000
Medium and Short Term Notes...... 3,599,000 (13,000) 3,586,000
Euro Dollar Bonds................ 2,388,000 (2,000) 2,386,000
Taxable Auction Securities....... 4,000,000 4,000,000
----------- ------ ---------- -----------
$17,292,000 $ -- $ (35,000) $17,257,000
=========== ====== ========== ===========
1999
U.S. Corporate Debt Securities... $26,390,000 $1,000 $ (81,000) $26,310,000
Medium and Short Term Notes...... 14,350,000 (57,000) 14,293,000
Euro Dollar Bonds................ 3,895,000 (15,000) 3,880,000
Taxable Auction Securities....... 8,000,000 8,000,000
----------- ------ ---------- -----------
$52,635,000 $1,000 $ (153,000) $52,483,000
=========== ====== ========== ===========
</TABLE>

All held-to-maturity investments at September 30, 2000 are due within one
year.

Long-term investments at September 30, 2000 consist entirely of an
investment in a privately held company, which is recorded at cost.

34
<PAGE> 36
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

4. PROPERTY AND EQUIPMENT

Property and equipment consists of the following:

<TABLE>
<CAPTION>
SEPTEMBER 30,
--------------------------
2000 1999
----------- -----------
<S> <C> <C>
Computer equipment...................................... $11,469,000 $ 4,615,000
Furniture and fixtures.................................. 1,071,000 376,000
Leasehold improvements.................................. 1,033,000 142,000
Internal use software................................... 1,374,000 485,000
Other Assets -- Vehicles................................ 174,000 --
----------- -----------
15,121,000 5,618,000
Less: Accumulated depreciation and amortization......... (4,929,000) (1,628,000)
----------- -----------
$10,192,000 $ 3,990,000
=========== ===========
</TABLE>

Depreciation expense was approximately $3,301,000, $1,159,000 and $322,000
for the years ended September 30, 2000, 1999, and 1998.

5. LONG-TERM DEBT

Long term debt consisted of the following at September 30, 2000:

<TABLE>
<S> <C>
Equipment advances from Imperial Bank....................... $ 4,722,000
Less: Current portion....................................... (1,646,000)
-----------
$ 3,076,000
===========
</TABLE>

On April 6, 2000, the Company drew a $2 million equipment advance from its
term loan and line of credit facility with Imperial Bank. The advance is
collateralized by a first priority security interest in all of the Company's
unpledged assets. Borrowings under this facility are payable in thirty-six equal
monthly installments of principal plus accrued interest. Interest is accrued at
the bank's prime rate plus 1.0%, or 10.5% at September 30, 2000.

On September 20, 2000, the Company amended and restated its term loan and
line of credit facilities with Imperial Bank. Under the amended and restated
agreement, the Company drew an additional equipment advance for $3 million on
September 29, 2000. The advance is collateralized by a first priority security
interest in all of the Company's unpledged assets. Borrowings under this
facility are payable in thirty-six monthly installments of principal plus
accrued interest. Interest is accrued at the bank's prime rate plus 1.0%, or
10.5% at September 30, 2000.

The amended and restated agreement also provides for a revolving line of
credit for draws of 80% of accounts receivable assigned as security up to a
maximum short-term borrowing of $2.5 million, if specified conditions are met.
The Company's available borrowings under the line of credit are reduced by an
irrevocable standby letter of credit in the amount of $715,000, which expires on
July 31, 2005. Advances on the revolving line of credit bear interest on the
outstanding daily balance at a rate of 0.5% above the bank's prime rate.

Debt outstanding at September 30, 2000 becomes due as follows:

<TABLE>
<S> <C>
Years Ending September 30,
2001........................................................ $1,646,000
2002........................................................ 1,707,000
2003........................................................ 1,369,000
----------
Total amount due.................................. $4,722,000
==========
</TABLE>

35
<PAGE> 37
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

6. LEASE COMMITMENTS

The Company's property held under capital leases, which is included in
property and equipment at September 30, 2000, 1999, and 1998, consists primarily
of computer equipment in the gross amount of $606,000, $2,644,000, and
$1,006,000, respectively. Related accumulated amortization for those assets is
$219,000, $675,000, and $189,000 for the years then ended. The Company is also
committed under operating leases for its headquarter facilities which includes a
lease escalation clause. Rent expense for the years ended September 30, 2000,
1999, and 1998 was $1,311,000, $307,000, and $188,000, respectively.

Subsequent to year end, the Company amended its headquarters lease
agreement to decrease the total leased space from approximately 56,000 square
feet to approximately 43,000 square feet, which will thereby reduce the minimal
operating lease commitments by approximately $435,000 per year beginning October
15, 2000. Reflecting this amendment, the minimum annual rental commitments on
all leases at September 30, 2000 are as follows:

<TABLE>
<CAPTION>
OPERATING CAPITAL
LEASE LEASES
---------- ---------
<S> <C> <C>
Years Ending September 30,
2001........................................................ $1,255,000 $ 241,000
2002........................................................ 1,291,000 202,000
2003........................................................ 1,334,000 18,000
2004........................................................ 1,375,000 --
2005........................................................ 1,275,000 --
Thereafter.................................................. -- --
---------- ---------
Total minimum lease payments...................... $6,530,000 461,000
==========
Less: Amount representing interest.......................... (34,000)
---------
Present value of capital lease obligation................... 427,000
Less: Current portion....................................... (205,000)
---------
Long-term obligations at September 30, 2000................. $ 222,000
=========
</TABLE>

7. BUSINESS COMBINATION

On February 23, 2000, the Company acquired iseek Pty Limited (iseek), a
privately held company incorporated in Queensland, Australia, in an all-stock
transaction. The transaction was accounted for as a purchase.

As consideration, the shareholders of iseek received 925,000 shares of the
Company's common stock. The shares were valued using the market price of the
Company's common stock for the two days before and after the acquisition was
announced. A total of 512,000 of the shares issued were issued to the founders
of iseek and are subject to an escrow provision. The escrowed shares will be
released equally over three years, based on the continued employment of the
founders. The value of these shares has been treated as deferred compensation
and will be amortized over the three-year employment period. As of September 30,
2000, the Company has recorded $3,176,000 of related compensation expense.

In addition, the Company issued a warrant for 100,000 shares of common
stock at the exercise price of $22.50 to certain iseek shareholders in exchange
for a covenant not to compete. The fair value of the warrants was determined
using the Black-Scholes option pricing model, using a 95% volatility factor, an
expected life of 5 years, and a risk-free interest rate of 6.38%.

36
<PAGE> 38
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

The total purchase price was as follows:

<TABLE>
<S> <C>
Common stock issued......................................... $16,104,000
Warrant issued.............................................. 1,255,000
Acquisition costs incurred.................................. 287,000
Liabilities assumed......................................... 54,000
-----------
Total purchase price.............................. $17,700,000
===========
</TABLE>

The total purchase price of $17,700,000 was allocated to the fair value of
the assets acquired as follows:

<TABLE>
<CAPTION>
AMORTIZATION
LIFE
------------
<S> <C> <C>
Tangible assets............................................ $ 210,000 --
Intangible assets:
Client redirect software................................. 919,000 5
Customer lists........................................... 572,000 5
Covenant not to compete.................................. 1,255,000 5
Goodwill................................................. 5,834,000 5
-----------
Total intangible assets.......................... 8,580,000
Deferred compensation...................................... 8,910,000 3
-----------
Total purchase price............................. $17,700,000
===========
</TABLE>

Intangible assets are amortized on a straight-line basis. Deferred
compensation is amortized using an accelerated method in accordance with
Financial Accounting Standards Board's interpretation number 28.

The following pro forma financial information is unaudited and gives effect
to the acquisition, assuming that the acquisition took place as of October 1,
1998:

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
----------------------------
2000 1999
------------ ------------
(UNAUDITED)
<S> <C> <C>
Revenue................................................. $ 10,987,000 $ 6,699,000
Net loss................................................ $(41,089,000) $(14,998,000)
Basic and diluted net loss per share.................... $ (1.89) $ (1.07)
</TABLE>

The results of operations of iseek have been included in the Company's
Consolidated Statement of Operations since the purchase date.

In September 2000, as a result of iseek's operations not meeting expected
forecasts, the Company recorded a $6.1 million write down of the carrying value
of the iseek acquired intangible assets. The write-down was applied first
against goodwill, with the excess applied against other acquired intangible
assets. The impairment loss was calculated as the excess of the present value of
future cash flows and the estimated terminal value over the carrying value of
the intangible assets.

8. RELATED PARTY TRANSACTIONS

During the year ended September 30, 2000, the Company entered into seven
separate note receivable agreements with four shareholders, three of which were
Officers of the Company. A total of $1,844,000 was loaned to shareholders during
the year. The notes bear interest at 8% per annum and mature between October
2000 and November 2001. The total balance due, including accrued interest, from
shareholders at September 30, 2000 amounted to $1,878,000. The carrying value of
these loans has been reduced by a provision of $805,000 to reflect amounts which
may not be collectible. Subsequent to September 30, 2000, the Company

37
<PAGE> 39
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

entered into agreements with two of the officers to accept certain shares of
common stock held by the officers in exchange for forgiveness of amounts due
under the notes. As a result of these transactions, a total of 810,000 shares of
common stock may be repurchased by the Company at prices between $1.00 and
$1.50. Compensation expense will be recorded to the extent that the repurchase
price is in excess of market at the repurchase date.

In August and September of 1999, the Company entered into four separate
recourse note receivable agreements bearing interest at 6% per annum with
employees totaling $25,000 in connection with the exercise of options. The notes
matured in February 2000.

In September 1998, the Company converted trade accounts receivable of
$30,000 from a related party into a note receivable bearing interest at 10.5%
per annum. The note was paid in full in December 1998.

9. INCOME TAXES

A provision for income taxes was not recorded for the periods ended
September 30, 2000, 1999 or 1998 due to taxable losses incurred during those
periods. A valuation allowance has been recorded for deferred tax assets as it
has been determined that it is more likely than not that these deferred tax
assets will not be realized.

The provision for federal income tax differs from the amount computed by
applying the statutory federal income tax rate for the following reasons:

<TABLE>
<CAPTION>
SEPTEMBER 30, SEPTEMBER 30,
2000 1999
------------- -------------
<S> <C> <C>
Federal income tax benefit at statutory rate.............. (34.0)% (34.0)%
Other..................................................... (0.2) 1.4
----- -----
Change in valuation allowance............................. 34.2 32.6
----- -----
0% 0%
----- -----
</TABLE>

Deferred tax assets and liabilities at September 30, 2000 consist of the
following:

<TABLE>
<CAPTION>
SEPTEMBER 30, SEPTEMBER 30,
2000 1999
------------- -------------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards....................... $ 11,880,000 $ 1,618,000
Cash to accrual adjustment............................. -- 491,000
Allowance for doubtful accounts........................ 98,000 48,000
Accrued compensation and benefits...................... 130,000 104,000
Depreciation and amortization.......................... 3,032,000 214,000
------------ -----------
Total deferred tax assets...................... 15,140,000 2,475,000
Cash to accrual adjustments............................ 338,000
Total deferred tax liabilities................. 338,000
Valuation allowance.................................... (14,802,000) (2,475,000)
------------ -----------
Net deferred tax asset................................. $ -- $ --
============ ===========
</TABLE>

As of September 30, 2000, the Company had net operating loss carryforwards
of approximately $34 million to offset future taxable income for Federal income
tax purposes, which will expire through 2020. Should certain changes in the
Company's ownership occur, there could be a limitation on the utilization of its
net operating losses.

38
<PAGE> 40
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

10. FACTORING AGREEMENT

During fiscal 1999, the Company terminated its factoring agreement with the
bank. Prior to that, pursuant to a factoring agreement entered into in September
1997 and amended July 14, 1998, the Company's bank acted as its factor for the
majority of its receivables, assigned on a pre-approved, full recourse basis, up
to $1,000,000. The Company sold its eligible receivables at a 0.3% discount to
face value and was charged 1.6% of uncollected assigned balances per month.
Pursuant to the agreement, the Company repurchased any assigned receivables
outstanding 90 days after the invoice date. Total interest paid on factored
receivables was $35,000 and $86,000 during 1999 and 1998, respectively.

11. STOCK PURCHASE WARRANTS

On March 11, 1999, the Company redeemed an outstanding warrant for 50,000
shares of its common stock, and recorded a redemption charge of $185,000 in
fiscal 1999.

Pursuant to the acquisition of iseek Limited, the Company issued a warrant
on February 23, 2000 for the purchase of 100,000 shares of common stock at an
exercise price of $22.50 per share. The warrant expires on February 23, 2004 and
may be exercised at any time. The fair market value of the warrant on the date
of grant was $1,254,800 and has been accounted for in the purchase of iseek.

The following summarizes stock purchase warrant activity for fiscal 1998,
1999, and 2000:

<TABLE>
<S> <C>
Balance at September 30, 1997............................... 1,283,330
Warrants issued............................................. 222,728
----------
Balance at September 30, 1998............................... 1,506,058
Warrants issued............................................. 558,000
Warrants canceled........................................... (1,599,058)
Warrants exercised.......................................... (6,342)
----------
Balance at September 30, 1999............................... 458,658
Warrants Issued............................................. 100,000
Warrants Exercised.......................................... (19,375)
----------
Balance at September 30, 2000............................... 539,283
==========
</TABLE>

The Company recorded compensation expense of $0, $77,000, and $12,000 in
2000, 1999, and 1998, respectively, related to the issuance of these warrants.
Additionally, the Company has issued options to certain non-employees under the
1999 Stock Option Plan as described below.

12. STOCK OPTION PLANS

Effective September 30, 1997, the Company adopted the 1997 Stock Option
Plan (the 1997 Plan) for employees, directors, consultants or independent
contractors under which 2,187,500 shares of common stock are reserved for stock
option grants. Effective April 2, 1999, the Company adopted the 1999 Stock
Option Plan (the 1999 Plan) for employees, directors, consultants or independent
contractors under which 1,329,625 shares of common stock are reserved for stock
option grants. Effective September 14, 1999 the Company adopted the 1999/2000
Transition Plan (the 1999/2000 Plan) for employees, consultants, and independent
contractors under which 750,000 shares of common stock are reserved for stock
option grants. On November 8, 1999 the number of shares was increased by 500,000
shares to 1,250,000 by the Board of Directors. Effective November 8, 1999, the
Company adopted the 2000 Stock Option Plan (the 2000 Plan) for employees and
consultants under which 4,000,000 shares of common stock are reserved for stock
option grants. Pursuant to all plans, the Board of Directors may grant
nonqualified and incentive stock options. The vesting period, exercise price and
expiration period of options are established at the discretion of the Board of

39
<PAGE> 41
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

Directors, except that the exercise price of incentive stock options must equal
the fair market value of the underlying common stock on the date of the grant.
Option grants to date generally vest over a two, three, or four-year period and
expire ten years from the date of grant.

Effective July 30, 1999 the Company adopted the Non-Employee Director Stock
Option Plan, under which the Board of Directors has provided for the automatic
grant of options to purchase shares of common stock to non-employee directors of
the Company. The Company has reserved a total of 87,500 shares of common stock
for issuance as nonqualified stock options to non-employee directors. The
options are priced based on the fair market value on the date of grant and
become fully exercisable following the sixth month after grant date. Options
granted under this plan are exercisable at any time prior to the expiration date
of the stock option or within three months after the date the grantee ceases to
be a director, whichever is shorter.

During fiscal 1999 and 2000 the Company issued 900,000 and 460,000 options,
respectively, to employees outside of the authorized plans referenced above
which, when exercised, constitute securities which have not been registered
under the Securities Act of 1933, as amended. The vesting period, exercise price
and expiration period of these nonqualified options are established at the
discretion of the Board of Directors.

The following summarizes the activity under the Company's Stock Option
Plans:

<TABLE>
<CAPTION>
OPTIONS
ISSUED
1997 1999 DIRECTORS 1999/2000 2000 OUTSIDE
OPTIONS OUTSTANDING PLAN PLAN PLAN PLAN PLAN PLANS TOTAL
------------------- --------- ---------- --------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at September 30,
1997....................... 1,827,438 1,827,438
Options granted............ 696,500 696,500
Options exercised.......... (374,062) (374,062)
Options cancelled.......... (465,938) (465,938)
--------- ---------- ------ ---------- ---------- ---------- ----------
Balance at September 30,
1998....................... 1,683,938 1,683,938
Options granted............ 198,249 1,327,624 3,750 900,000 2,429,623
Options exercised.......... (792,603) (792,603)
Options cancelled.......... (83,500) (11,250) (94,750)
--------- ---------- ------ ---------- ---------- ---------- ----------
Balance at September 30,
1999....................... 1,006,084 1,316,374 3,750 900,000 3,226,208
Options granted............ 63,400 66,233 1,496,625 1,366,385 460,000 3,452,643
Options exercised.......... (384,539) (152,857) (537,396)
Options cancelled.......... (58,925) (136,879) (449,750) (72,165) (1,080,000) (1,797,719)
--------- ---------- ------ ---------- ---------- ---------- ----------
Balance at September 30,
2000....................... 626,020 1,092,871 3,750 1,046,875 1,294,220 280,000 4,343,736
========= ========== ====== ========== ========== ========== ==========
</TABLE>

<TABLE>
<CAPTION>
OPTIONS
ISSUED
1997 1999 DIRECTORS 1999/2000 2000 OUTSIDE
OPTIONS AVAILABLE PLAN PLAN PLAN PLAN PLAN PLANS TOTAL
----------------- --------- ---------- --------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at September 30,
1997....................... 360,062 360,062
Options granted............ (696,500) (696,500)
Options cancelled.......... 465,938 465,938
--------- ---------- ------ ---------- ---------- ---------- ----------
Balance at September 30,
1998....................... 129,500 129,500
Shares authorized.......... 1,329,625 87,500 750,000 2,167,125
Options granted............ (198,249) (1,327,624) (3,750) (900,000) (2,429,623)
Options cancelled.......... 83,500 11,250 94,750
--------- ---------- ------ ---------- ---------- ---------- ----------
Balance at September 30,
1999....................... 14,751 13,251 83,750 750,000 (900,000) (38,248)
Shares authorized.......... 500,000 4,000,000 4,500,000
Options granted............ (63,400) (66,233) (1,496,625) (1,366,385) (460,000) (3,452,643)
Options cancelled.......... 58,925 136,879 449,750 72,165 1,080,000 1,797,719
--------- ---------- ------ ---------- ---------- ---------- ----------
Balance at September 30,
2000....................... 10,276 83,897 83,750 203,125 2,705,780 (280,000) 2,806,828
========= ========== ====== ========== ========== ========== ==========
</TABLE>

40
<PAGE> 42
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

<TABLE>
<CAPTION>
OPTIONS
1999/ ISSUED
1997 1999 DIRECTORS 2000 2000 OUTSIDE
WEIGHTED AVERAGE EXERCISE PRICES PLAN PLAN PLAN PLAN PLAN PLANS TOTAL
-------------------------------- ------ ----- --------- ------ ----- ------- ------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at September 30, 1997........ $ 0.18 $ -- $ -- $ -- $ -- $ -- $ 0.18
Options granted.................... 0.25 0.25
Options exercised.................. 0.20 0.20
Options cancelled.................. 0.18 0.18
------ ----- ------ ------ ----- ------ ------
Balance at September 30, 1998........ $ 0.21 $ -- $ -- $ -- $ -- $ -- $ 0.21
Options granted.................... 1.46 3.08 11.00 9.48 5.33
Options exercised.................. 0.20 0.20
Options cancelled.................. 0.77 3.70 1.12
------ ----- ------ ------ ----- ------ ------
Balance at September 30, 1999........ $ 0.42 $3.07 $11.00 $ $ $ 9.48 $ 4.04
Options granted.................... 14.00 5.47 11.63 3.11 14.04 8.50
Options exercised.................. 0.27 2.20 0.82
Options cancelled.................. 0.67 3.35 12.30 2.91 11.35 10.29
------ ----- ------ ------ ----- ------ ------
Balance at September 30, 2000........ $1.882 $3.31 $11.00 $11.34 $3.12 $ 9.74 $ 5.40
====== ===== ====== ====== ===== ====== ======
</TABLE>

The Company applies the accounting provisions prescribed in APB 25 and
related interpretations. In certain instances, the Company has issued stock
options with an exercise price less than the deemed fair value of the Company's
common stock at the date of grant. Deferred compensation related to these stock
options of approximately $2,151,000 was recorded during fiscal 1999 and is being
amortized over the vesting period of the options of three to four years.
Amortization of unearned compensation costs of approximately $423,000 and
$815,000 has been recognized as an expense for in fiscal 1999 and 2000,
respectively. During fiscal 2000, the Company accelerated the vesting of options
for 354,167 shares relating to the termination of certain employees and resulted
in recognition of $148,000 of compensation expense in fiscal 2000.

During fiscal 1999, deferred compensation costs of $551,000 was recorded on
warrants issued to non-employees of which $339,000 was amortized. During fiscal
2000, the warrants were re-priced and vesting accelerated resulting in an
additional deferred compensation of $56,000 and amortization of $243,000.

During fiscal 1999, the Company settled lawsuits with former employees who
were terminated in fiscal 1998. In connection with the settlements, the Company
extended the exercise period for stock options previously granted to one of the
employees and granted stock to the other employee. The Company recorded
compensation expense of $807,000 related to these transactions in the September
30, 1998 financial statements.

In connection with the issuance of 512,000 shares to iseek personnel, the
Company recorded deferred compensation of $8.9 million. As of September 30,
2000, the Company recognized compensation expense of $3,176,000 associated with
these shares (Note 7).

Pro forma information regarding net loss is required by SFAS No. 123, and
has been determined as if the Company had accounted for its stock options and
stock purchase plan under the minimum value method of that statement for all
periods prior to the Company becoming a public entity and fair value method of
that statement for all periods subsequent to the Company becoming a public
entity. The fair value of each option is

41
<PAGE> 43
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

estimated at the date of grant with the following weighted-average assumptions
used for the years ended September 30, 2000, 1999 and 1998:

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-----------------------------
2000 1999 1998
------- ------- -------
<S> <C> <C> <C>
Risk-free interest rate................................. 6.5% 5.3% 4.8%
Dividend yield.......................................... 0.0% 0.0% 0.0%
Expected term of option................................. 5 years 5 years 5 years
Volatility subsequent to initial public offering........ 95.0% 95.3% --
</TABLE>

For purposes of pro forma disclosures, the estimated fair value of the
option is amortized over the options' vesting period. The Company's pro forma
net loss would have been as follows:

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
------------------------------
2000 1999 1998
-------- ------- -------
<S> <C> <C> <C>
Net loss as reported................................. $(39,258) $(7,721) $(2,597)
Net loss pro forma................................... (46,025) (8,447) (2,623)
Net loss per share as reported....................... (1.82) (0.57) (0.30)
Net loss per share pro forma......................... (2.13) (0.62) (0.30)
</TABLE>

The weighted-average fair values and weighted-average exercise prices per
share at the date of grant for options granted for the years ended September 30,
2000, 1999 and 1998 were as follows:

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
------------------------
2000 1999 1998
------ ----- -----
<S> <C> <C> <C>
Weighted-average fair value of options granted with
exercise prices equal to the market value of the stock at
the date of grant........................................ $ 6.34 $2.66 $0.05
Weighted-average fair value of options granted with
exercise prices less than the market value of the stock
at the date of grant..................................... -- 8.05 --
Weighted-average fair value of options granted with
exercise prices greater than the market value of the
stock at the date of grant............................... 9.34 2.18 --
Weighted-average exercise price of options granted with
exercise prices equal to the market value of the stock at
the date of grant........................................ 8.43 3.59 --
Weighted-average exercise price of options granted with
exercise prices less than the market value of the stock
at the date of grant..................................... -- 9.30 --
Weighted-average exercise price of options granted with
exercise prices greater than the market value of the
stock at the date of grant............................... 11.43 3.37 --
</TABLE>

The following table summarizes information about fixed-price options
outstanding at September 30, 2000 as follows:

<TABLE>
<CAPTION>
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE NUMBER REMAINING EXERCISE NUMBER EXERCISABLE
PRICES OUTSTANDING CONTRACTUAL LIFE PRICE EXERCISABLE PRICE
-------- ----------- ---------------- --------- ----------- -----------
<S> <C> <C> <C> <C> <C>
$ 0.18 - $ 1.16 632,806 7.87 $ 0.50 385,247 $ 0.47
$ 2.78 839,770 9.84 $ 2.78 -- --
$ 2.93 - $ 3.37 761,526 8.58 $ 3.17 297,815 $ 3.19
$ 3.50 - $ 4.88 796,425 9.48 $ 3.86 73,873 $ 3.70
$ 4.91 - $10.28 861,483 9.21 $ 8.56 47,036 $ 8.71
$10.47 - $23.36 451,725 9.32 $17.59 6,281 $11.00
</TABLE>

42
<PAGE> 44
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

13. EMPLOYEE STOCK PURCHASE PLAN

Effective November 8, 1999, the Company adopted the Employee Stock Purchase
Plan. The plan authorizes the issuance of a maximum of 750,000 shares of common
stock. All employees who work more than twenty hours per week or five months per
year and have been employed longer than six months are eligible to participate
with the exception of those owning 5% or more of the combined voting power of
the Company's stock. Employees elect to have deducted from 1% to 10% of their
base compensation up to $25,000 per year. The exercise price for the option is
the lesser of 85% of the fair market value of the common stock on the first or
last day of the six month offering period with a limit of 1,000 shares of common
stock per employee applied at each purchase date. Actual shares purchased by
participating employees as of September 30, 2000 totaled 36,453 at an average
exercise price of $2.13.

14. COMMON STOCK

On September 30, 1997, September 30, 1998, and July 8, 1999, the Board of
Directors declared a one hundred twenty five-for-one, a seven-for-one, and a
five-for-two stock split, respectively, on the Company's common stock effected
in the form of a stock dividend to holders of record on these dates. Common
stock issued and stock option information in these financial statements have
been restated to reflect these splits.

As of May 10, 1999, the Company amended its Articles of Incorporation to
authorize the issuance of 50,000,000 shares of preferred stock and 250,000,000
shares of common stock at no par value. The terms of the preferred stock are to
be set by the Board of Directors.

On May 11, 1999, the Company completed a private equity financing in which
2,443,215 shares of common stock were sold to investors at $3.70 per share for
an aggregate of $8,830,122, net of issuance costs. In connection with this
financing, the Company satisfied promissory notes plus accrued interest totaling
$970,005 by issuing 262,447 shares of common stock.

On July 29, 1999, the Company completed its initial public offering of
5,000,000 shares of common stock at a purchase price of $13.00 per share. Of the
shares sold, 4,950,000 were sold by the Company, and 50,000 were offered by a
group of selling shareholders. Net proceeds received by the Company were $58.4
million.

On February 23, 2000, the Company issued 925,000 shares of common stock in
connection with the acquisition of iseek (Note 7).

15. NET LOSS PER SHARE

A reconciliation of the basic and diluted earnings per share to the shares
used is as follows:

<TABLE>
<CAPTION>
SEPTEMBER 30,
----------------------------------------
2000 1999 1998
------------ ----------- -----------
<S> <C> <C> <C>
Net loss....................................... $(39,258,000) $(7,721,000) $(2,597,000)
Weighted-average shares outstanding -- basic... 21,578,000 13,620,000 8,687,000
Weighted-effect of dilutive options and
warrants..................................... -- -- --
------------ ----------- -----------
Weighted-average shares
outstanding -- diluted....................... 21,578,000 13,620,000 8,687,000
============ =========== ===========
Basic and diluted net loss per share........... $ (1.82) $ (.57) $ (.30)
============ =========== ===========
</TABLE>

A total of 512,000 restricted shares and warrants and options to purchase a
total of 539,280 and 4,343,735 shares of common stock, respectively, have been
excluded from the calculation of net loss per share for fiscal 2000 because
their effect is anti-dilutive. Warrants and options to purchase a total of
458,658 and 3,226,207 shares of common stock, respectively, for fiscal 1999 and
1,506,058 and 1,683,938 shares of common stock,

43
<PAGE> 45
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

respectively for fiscal 1998 have been excluded from the calculation of net loss
per share because of their effect is anti-dilutive.

16. COMMITMENTS AND CONTINGENCIES

The Company is from time to time involved in various claims and legal
proceedings of a nature considered by management to be routine and incidental to
its business. In the opinion of the Company's management, after consultation
with outside legal counsel, the ultimate disposition of such matters is not
expected to have a material adverse effect on the Company's financial position,
results of operations or liquidity.

17. SETTLEMENT OF LAWSUIT

On June 25, 1999, Spyglass, Inc. filed a patent infringement lawsuit
against the Company in United States District Court for the Northern District of
California. The suit alleged that the making, use and sale of the Company's
internet filtering systems infringed a United States patent held by Spyglass. In
December 1999, the Company settled the lawsuit with Spyglass, Inc. The
settlement resulted in a nonexclusive, nontransferable, nonrefundable lump-sum
license agreement for the Company to make, use, sell or otherwise distribute the
products and services which Spyglass alleged infringement. The Company paid
$650,000 in consideration of the license granted.

44
<PAGE> 46
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

18. SUPPLEMENTAL CASH FLOW INFORMATION

Supplemental disclosure of cash flow information is summarized below for
the years ended September 30, 2000, 1999, and 1998:

<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30,
-------------------------------------
2000 1999 1998
----------- ---------- --------
<S> <C> <C> <C>
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Acquisition of iseek in non-cash transaction:
Stock and warrants issued................. $17,359,000
Acquired intangibles...................... 8,580,000
Additions to deferred compensation........ 8,910,000
Additions to property and equipment....... 101,000
Additions to intangibles and other
assets.................................. 51,000
Additions to accounts payable............. 54,000
Equipment obtained through capital lease..... $1,638,000 $757,000
Value ascribed to warrants issued with note
payable................................... 77,000
Conversion of notes payable to common
stock..................................... 1,693,000
Notes payable surrendered for the exercise
price of stock options.................... 75,000
Note receivable from shareholder for exercise
of options................................ 25,000
Unearned compensation........................ 2,702,000
Cash paid for interest....................... 376,000 541,000 178,000
</TABLE>

19. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

The following table sets forth the Company's unaudited quarterly financial
information for the years ending September 30, 2000 and 1999:

<TABLE>
<CAPTION>
FISCAL YEAR 2000
--------------------------------------------------------
SEPTEMBER 30 JUNE 30 MARCH 31 DECEMBER 31
------------ ----------- ---------- -----------
<S> <C> <C> <C> <C>
Revenue......................... $ 2,468,000 $ 3,324,000 $2,925,000 $2,256,000
Net loss........................ 16,894,000 10,326,000 6,919,000 5,119,000
Earnings per share:
Basic and diluted............. $ (0.77) $ (0.47) $ (0.32) $ (0.24)
</TABLE>

<TABLE>
<CAPTION>
FISCAL YEAR 1999
-------------------------------------------------------
SEPTEMBER 30 JUNE 30 MARCH 31 DECEMBER 31
------------ ---------- ---------- -----------
<S> <C> <C> <C> <C>
Revenue.......................... $2,126,000 $1,873,000 $1,453,000 $1,228,000
Net loss......................... 3,793,000 1,915,000 1,363,000 649,000
Earnings per share:
Basic and diluted.............. $ (0.20) $ (0.13) $ (0.11) $ (0.07)
</TABLE>

The Company has revised its purchase accounting for the acquisition of
iseek originally recorded and has accordingly amended its Forms 10-Q for the
second and third quarters of fiscal 2000, ended

45
<PAGE> 47
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2000, 1999, AND 1998

March 31, 2000 and June 30, 2000, respectively. The effect on the second and
third quarter results of operations and financial position are summarized as
follows:

<TABLE>
<CAPTION>
FISCAL YEAR 2000
--------------------------
THIRD SECOND
QUARTER QUARTER
----------- -----------
<S> <C> <C>
Net loss:
As reported............................................. $ 9,347,000 $ 6,593,000
As restated............................................. 10,326,000 6,919,000
Earnings per share, basic and diluted:
As reported............................................. $ (0.42) $ (0.31)
As restated............................................. $ (0.47) $ (0.32)
Total assets:
As reported............................................. $63,658,000 $70,531,000
As restated............................................. 56,513,000 63,003,000
Total shareholder's equity:
As reported............................................. $57,286,000 $66,953,000
As restated............................................. 50,141,000 59,425,000
</TABLE>

The changes made consist of a reclassification of goodwill to deferred
compensation in recognition of the founders' shares held in employment escrow
and an addition to acquired intangible assets in recognition of warrants issued
as part of the purchase consideration. The increase in net loss is the result of
an accelerated amortization method used for deferred compensation. None of these
changes had a cash impact to the Company.

(a)(2)

N2H2, INC.

VALUATION AND QUALIFYING ACCOUNTS AND RESERVES

<TABLE>
<CAPTION>
BALANCE AT CHARGES TO BALANCE AT
BEGINNING OF COSTS AND CHARGES TO END OF
DESCRIPTION FISCAL PERIOD EXPENSES OTHER ACCOUNTS FISCAL PERIOD
----------- ------------- ----------- -------------- -------------
<S> <C> <C> <C> <C>
Year Ended September 30, 1998
Allowance for doubtful accounts... -- (8,000) (8,000)
Year Ended September 30, 1999
Allowance for doubtful accounts... (8,000) (261,000) 127,000 (142,000)
Tax valuation allowance........... -- (2,475,000) (2,475,000)
Year Ended September 30, 2000
Allowance for doubtful accounts... (142,000) (369,000) 198,000 (313,000)
Tax valuation allowance........... (2,475,000) (12,327,000) (14,802,000)
</TABLE>

46
<PAGE> 48

PART III

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

Not applicable

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

The information required by this item with respect to the Company's
directors and compliance with Section 16(a) of the Exchange Act is included in
the following sections of the Company's Proxy Statement for its 2001 Annual
Meeting of Shareholders which sections are incorporated by reference herein and
will be filed within 120 days after the end of the Company's fiscal year:

Executive Officers of the Company
Election of Directors
Compliance with Section 16(a) of the Exchange Act of 1934

ITEM 11. EXECUTIVE COMPENSATION.

The information required under this item is included in the following
sections of the Company's Proxy Statement for its 2001 Annual Meeting of
Shareholders, which sections are incorporated by reference herein and will be
filed within 120 days after the end of the Company's fiscal year:

Compensation of Executive Officers in the Year Ended September 30, 2000
Compensation Committee Report on Executive Compensation
Stock Price Performance
Director Compensation

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

The information required under this item is included in the following
section of the Company's Proxy Statement for its 2001 Annual Meeting of
Shareholders, which section is incorporated by reference herein and will be
filed within 120 days after the end of the Company's fiscal year:

Security Ownership of Certain Beneficial Owners and Management

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

Election of Directors
Transactions with Management, Certain Transactions

47
<PAGE> 49

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

a. The following documents are filed as part of this report under Item 8:

<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
(1) Consolidated Financial Statements
Report of PricewaterhouseCoopers LLP., Independent
Auditors.................................................. 25
Consolidated Balance Sheets as of September 30, 2000 and
1999...................................................... 26
Consolidated Statements of Operations for the Fiscal Years
Ended September 30, 2000, 1999 and 1998................... 27
Consolidated Statements of Changes in Shareholders' Equity
(Deficit) for the Fiscal Years Ended September 30, 2000,
1999 and 1998............................................. 28
Consolidated Statements of Cash Flows for the Fiscal Years
Ended September 30, 2000, 1999 and 1998................... 29
Notes to Consolidated Financial Statements................ 30
(2) Financial Statement Schedule
Valuation and qualifying accounts and reserves............ 46
</TABLE>

b. Reports on Form 8-K

There were no reports on Form 8-K filed during the fourth quarter ended
September 30, 2000.

c. Exhibits. The following exhibits are filed or incorporated by reference
pursuant to Item 601 of Regulation S-K:

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
------- -----------------------
<C> <S>
3.1 Form of Restated Articles of Incorporation of the
registrant.(3.1)(1)
3.2 Amended Bylaws of the registrant.(3.2)(1)
4.1 Form of common stock certificate.(4.1)(1)
10.1 Union Bank of California Center Office Lease dated March 12,
1999, between Walton Seattle Investors I, L.L.C. and the
registrant.(10.3)(1)
10.2 1997 Stock Option Plan, as amended.(10.5)(1)
10.3 1999 Stock Option Plan.(10.6)(1)
10.4 1999 Nonemployee Director Stock Option Plan.(10.7)(1)
10.5 Search Engine Services Agreement dated January 19, 1998,
between Inktomi Corporation and the registrant.(10.8)(1)
10.6 Employment Agreement of Peter H. Nickerson dated May 10,
1999.(10.9)(1)
10.7 Employment Agreement of John F. Duncan dated May 10,
1999.(10.10)(1)
10.8 Registration Rights Agreement dated effective as of December
31, 1998.(10.12)(1)
10.9 Internet Data Center Services Agreement dated effective
August 31, 1998, between Exodus Communications, Inc. and the
registrant.(10.15)(1)
10.10 Amendment Agreement entered into June 30, 1999, to the
Search Engine Services Agreement dated January 19, 1999,
between Inktomi Corporation and the registrant.(10.16)(1)
10.11 Information Services Agreement dated June 30, 1999, between
Inktomi Corporation and the registrant.(10.17)(1)
10.12 First Amendment, dated June 16, 1999, to Union Bank of
California Office Lease of March 12, 1999, between Walton
Seattle Investors I, L.L.C. and the registrant.(10.1)(2)
10.13 Second Amendment, dated August 10, 1999, to Union Bank of
California Center Office Lease of March 12, 1999, between
Walton Seattle Investors I, L.L.C. and the
registrant.(10.2)(2)
</TABLE>

48
<PAGE> 50

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
------- -----------------------
<C> <S>
10.14 Technology License Agreement dated November 18, 1999 between
OneName Corporation and the registrant. (10.3)(3)
10.15 Data Services Agreement dated December 21, 1999 between
Inktomi Corporation and the registrant.(10.5)(3)
10.16 Distribution Agreement dated March 6, 2000 between Microsoft
Corporation and the registrant.(10.1)(4)
10.17 Promissory Note dated April 27, 2000 between Kevin Fink,
Chief Technology Officer, and the registrant. (10.1)(5)
10.18 Promissory Note dated May 17, 2000 between Kevin Fink, Chief
Technology Officer, and the registrant.(10.2)(5)
10.19 Promissory Note dated May 23, 2000 between Kevin Fink, Chief
Technology Officer, and the registrant.(10.3)(5)
10.20 Promissory Note dated April 27, 2000 between Peter Keane,
Former Vice President of Advertising, and the
registrant.(10.4)(5)
10.21 Promissory Note dated May 18, 2000 between Peter Keane,
Former Vice President of Advertising, and the
registrant.(10.5)(5)
10.22 Employment Agreement of Farzeen Mohazzabfar, dated November
5, 1999. (filed herewith)
10.23 Nonqualified Stock Option Agreement for Farzeen Mohazzabfar,
dated November 5, 1999. (filed herewith)
10.24 Employment Agreement of Richard Giacchetti, dated November
11, 1999. (filed herewith)
10.25 Nonqualified Stock Option Agreement for Richard Giacchetti,
dated November 11, 1999. (filed herewith)
10.26 Promissory Note dated August 2, 2000 between John Duncan,
former Chief Financial Officer, and the registrant. (filed
herewith)
10.27 Promissory Note dated November 1, 2000 between Kevin E.
Fink, Chief Technology Officer, and the registrant. (filed
herewith)
10.28 Amended and Restated Loan and Security Agreement dated
September 20, 2000, between Imperial Bank and the
registrant, together with exhibits thereto. (filed herewith)
10.29 2000 Stock Option Plan. (filed herewith)
10.30 Letter of employment for Paul Quinn, dated November 14,
2000. (filed herewith)
10.31 Redemption agreement dated November 3, 2000, between John
Duncan and the registrant. (filed herewith)
10.32 Employment Separation Agreement of John Duncan, dated
November 15, 2000. (filed herewith)
10.33 Employment Agreement of Kevin E. Fink, dated December 11,
2000. (filed herewith)
10.34 Redemption Agreement dated December 11, 2000, between Kevin
E. Fink and the registrant. (filed herewith)
27.1 Financial Data Schedule. (filed herewith)
</TABLE>

---------------
(1) Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrant's Registration Statement on Form
S-1 (File No. 333-78495).

49
<PAGE> 51

(2) Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrant's Form 10-Q for the quarter ended
June 30, 1999 (File No. 0-26825).

(3) Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrant's Form 10-Q for the quarter ended
December 31, 1999 (File No. 0-26825).

(4) Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrant's Form 10-Q for the quarter ended
March 31, 2000 (File No. 0-26825).

(5) Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrant's Form 10-Q for the quarter ended
June 30, 2000 (File No. 0-26825).

50
<PAGE> 52

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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, in the City of
Seattle, State of Washington, on December 28, 2000.

N2H2, Inc.

By: /s/ J. PAUL QUINN
------------------------------------
Vice President -- Chief Financial
Officer,
Secretary and Treasurer

<TABLE>
<CAPTION>
SIGNATURE TITLE
--------- -----
<S> <C>
/s/ PETER H. NICKERSON President, Chief Executive Officer, Chairman
--------------------------------------------- and Director (principal executive officer)

/s/ J. PAUL QUINN Vice President -- Chief Financial Officer,
--------------------------------------------- Secretary and Treasurer (principal financial
and accounting officer)

/s/ HOLLIS R. HILL Director
---------------------------------------------

/s/ MARK A. SEGALE Director
---------------------------------------------

/s/ RICHARD R. ROWE Director
---------------------------------------------
</TABLE>