The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes included in Item 8, "Financial Statements and Supplementary Data" in this Annual Report on Form 10-K. This discussion contains forward-looking statements, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward looking statements as a result of certain factors, including but not limited to those discussed in Item 1A "Risk Factors" and elsewhere in this Annual Report on Form 10-K. See discussion of forward-looking statements at the beginning of this Annual Report on Form 10-K.

OVERVIEW

ActivIdentity Corporation is a provider of digital identity assurance solutions for the enterprise, government, healthcare, and financial services markets worldwide for employer-to-employee, business-to-customer and government-to-citizen solutions. Trusted identity is the core of the ActivIdentity platform enabling security for data, networks, applications, passwords and credentials, web, email and documents, transactions, and converged security.

ActivIdentity® solutions support the convergence of physical and logical identity through strong authentication with smart card lifecycle management, adding enterprise single sign on, and data encryption and digital signature. ActivIdentity solutions include a fully-integrated platform, enabling organizations to issue, manage and use identity devices and credentials for secure access, secure communications, legally binding digital transactions, and intelligent citizen services.

Our products enable strong authentication utilizing a range of security methods and devices such as Smart Employee ID, Enterprise SSO, Strong Authentication, Secure Information and Transactions, and Smart Citizen ID. ActivIdentity products include SecureLogin ® SSO, ActivClient™ smart card middleware, ActivID™ Card Management System, 4TRESS™ AAA Server, one-time password (OTP) tokens, soft OTP tokens for mobile phone and personal digital assistants and ActivKey™ USB tokens. These devices enable organizations to address their security, compliance and auditing requirements by confirming identities before granting access to computer systems, networks, applications and physical locations.

Our customers experience multiple benefits including increased network security, protection against identity theft and online fraud, enhanced workforce productivity, business process efficiencies, and regulatory compliance.

Our Strategy: In March and April 2008, we experienced significant turnover among members of the Board of Directors and senior level officers. As a result of these changes, we essentially have a new Board and management team, and they are currently assessing our strategic focus and priorities. In connection with this assessment, the Board is expected to consider a number of potential actions over the next 12 months, including a potential return of capital to stockholders, either through a stock repurchase plan or special dividend, acquisitions or divestitures of assets and product lines to reorganize the Company in line with its strategic focus, and further restructurings of our operations. Any of these actions could significantly affect our operations, financial results, prospects and stock price.

Industry Outlook: We believe the digital identity market is a rapidly emerging global industry, driven by new government regulations, growing awareness of the risks of identity theft, and the growth in electronic commerce. While the industry is still in the early stage of development, industry-wide standards are evolving. A significant element of our business model is premised on the smart card becoming a common access platform for protecting an organization's assets, including network infrastructures, employees, customers, and confidential data. Issues driving industry growth and standardization are often unique across our target customer base, especially in international locations. We continue to monitor the evolution of the digital identity market and adapt products and services to best position the Company to realize competitive advantage. Additional challenges and risks that our product lines face include, but are not limited to: price and product feature competition, evolving technological change in the network security market, and risk of bugs and other errors in the software.

Financial Performance Indicators: We have a long and often complicated sales cycle dependent on a relatively small number of large deals, which can result in significant revenue fluctuations between periods. The typical sales cycle is six to nine months for an enterprise customer and over twelve months for a network service provider or government agency. As a result, in addition to monitoring financial performance based on reported revenues, management analyzes the probability of future transactions in the open deal pipeline when assessing financial condition and operating performance. Trends in deferred revenues, maintenance renewal contracts, and customer, geographic, or product mix are also integral to management's decision making process.

Strategic Initiatives: We are currently aligning our business model to shadow customer markets more effectively, focusing product lines on employer-to-employee, government-to-citizen, and business-to-customer strategic initiatives. We are also developing financial performance benchmarks to quantify the financial impacts of the revised strategic alignment and provide additional tools to assist management in assessing our financial condition. Restructuring and related cost cutting plans implemented to date have helped to streamline the Company and management will continue to identify areas for strategic improvement, in both revenue growth and cost containment.

SIGNIFICANT EVENTS

Restructurings: As of September 30, 2008, we are still obligated to pay $1.6 million (net of sub-lease income) for the vacated Fremont, California facility over the remaining lease term ending February 2011.

Significant or Unusual Items: During fiscal year 2008 the following items impacted our net loss.

º •
º Other-than-temporary impairment of investments-During the quarter ended March 31, 2008, certain auction rate securities were reduced to a value that we deem to be the fair market value of these securities resulting in a $3.0 million expense recorded through other income. During the

º •
º Goodwill impairment-During the quarter ended March 31, 2008, goodwill was determined to be fully impaired and a $35.9 million expense recorded through operating expenses.

º •
º Severance expense-At September 30, 2008, employee headcount was 260, down 19% or 62 employees from September 30, 2007. Associated with the reduction in headcount, we recorded $2.8 million in severance expense, primarily through operating expenses, for fiscal year 2008 as we continue to realign our business in accordance with our revised strategic initiatives. Cost savings associated with the headcount reduction should be recognized in fiscal year 2009 as our strategic realignment is executed.

º •
º Liquidation of inactive foreign subsidiary-During the quarter ended June 30, 2008, we liquidated an inactive foreign subsidiary resulting in $1.9 million of accumulated translation adjustment loss being reclassified from equity to other income. The accumulated losses resulted from the historic translation of the foreign entity's Australian dollar denominated local books in the Company's consolidation process.

º •
º Foreign exchange losses-For the year ended September 30, 2008, we recorded a realized loss on foreign exchange of $0.4 million and an unrealized loss on foreign exchange of $1.6 million on our consolidated statement of operations. Realized losses resulted from foreign exchange rate fluctuations between the initiation and settlement of transactions denominated in a non-functional currency of the associated entity. Unrealized losses resulted from the revaluation of assets and liabilities denominated in a non-functional currency on the balance sheets of the associated entities. The losses were primarily driven by fourth quarter strengthening of the U.S. dollar, specifically against the Euro, British Pound, and Australian dollar.

RESULTS OF OPERATIONS

Executive Summary

º •
º Our revenues for the fiscal year ended September 30, 2008 were $59.0 million, essentially flat compared to revenue of $59.6 million for the fiscal year ended September 30, 2007.

º •
º Our gross profit for the year ended September 30, 2008 was $35.3 million, a decrease of $3.7 million, or 9% compared to gross profit of $39.0 million for the year ended September 30, 2007. Gross margin declined by approximately 5 percentage points in fiscal 2008 compared to 2007.

º •
º Our net loss for the year ended September 30, 2008 was $76.5 million, an increase of $67.2 million, or 723% compared to net loss of $9.3 million for the year ended September 30, 2007.

Comparison of Fiscal Years ended September 30, 2008, 2007 and 2006

Certain prior periods' revenues and cost of revenues have been reclassified to conform with the current period's presentation. See further discussion of reclassified amounts in Note 1-Nature of Business and Summary of Significant Accounting Policies to the consolidated financial statements.

REVENUE

    Total revenue, mix by type, and period-over-period changes are as follows
(dollars in thousands):


                         Twelve Months                        Twelve Months
                             Ended                                Ended
                         September 30,       Percentage       September 30,       Percentage
                        2008       2007        Change        2007       2006        Change
    Software          $ 19,589   $ 19,363              1 % $ 19,363   $ 21,236             -9 %
    Hardware            15,078     16,894            -11 %   16,894     14,294             18 %
    Service             24,342     23,296              4 %   23,296     17,845             31 %

      Total revenue   $ 59,009   $ 59,553             -1 % $ 59,553   $ 53,375             12 %

The business has varying revenue streams, each of which is unique in terms of its recurring nature, transactional pricing, and volume characteristics. Software revenues are driven by irregularly occurring and unpredictable orders of significant size that are dependent on the closing of the transactions for revenue recognition purposes and can result in significant variances period over period. As hardware revenues are generally derived from the sale of software products, the variability in software revenue is the driving factor in the fluctuations of this revenue stream, although timing of hardware sales may lag the initial sale of related software. Maintenance revenue, the most significant component of service revenue, is tied directly to the installed base of customers, which fluctuates with the ability to attract new customers and the level of renewal activity with existing customers. The timing of closure of software transactions in the pipeline is the single most relevant trend in the Company's recorded revenue.

Our software revenue is comprised of software license revenue and professional services revenue essential to the functionality of software. While total software revenue remained essentially flat in fiscal 2008 compared to fiscal 2007, authentication software revenue increased $2.7 million or 85% and client middleware revenue increased $1.6 million or 96%, offset by decreases in card management software of $2.6 million or 39% and single sign on software of $1.4 million or 24%. Fluctuations in software revenue are driven primarily by the timing of the closure of relatively large transactions and are not indicative of a long-term trend in the business.

The decrease in software revenue of 9% in fiscal 2007 compared to fiscal 2006 is mainly attributable to a strong fourth quarter of fiscal 2006 in the government business that did not recur in fiscal 2007. Among the factors attributed to the lower government software revenue are lower U.S. governmental spending in fiscal 2007 and delays in the timing of large deals.

Hardware revenue is comprised of tokens, readers, smart cards, and related equipment, generally to complement sales of related software products. Hardware revenue decreased $1.8 million or 11% in fiscal 2008 compared to the prior year. Increased revenue of $0.8 million (to $10.2 million for fiscal 2008) or 8% on token sales was offset by a $1.7 million or 38% decrease in smart cards and a $0.9 million or 40% decrease in readers. Decreases in card management software revenues were a significant driver in the decrease of smart card and reader sales during the year.

The increase in hardware revenue of 18% between fiscal 2007 and 2006 was driven primarily by an increase of $1.9 million in smart cards sales as a result of continued acceptance of our card management system software, particularly by European governmental agencies. Additionally, we saw an increase of approximately $0.7 million in hardware sales as a result of stronger token business in Europe primarily to the financial sector.

Service revenue consists of post-contract customer support and professional services not essential to the functionality of software, including installation, training, and consulting. Fiscal 2008 post-contract customer support revenue increased $0.6 million, to $19.8 million, or 3% over fiscal 2007 on a growing

installed customer base. Professional service revenue on projects not essential to the functionality of software increased $0.5 million, to $4.5 million, or 14% over the prior fiscal year. While service revenue continued to trend upward, the year over year rate of growth was down in fiscal 2008 compared to fiscal 2007 as revenue spiked in 2007 on the renewal of several significant expired maintenance contracts.

Service revenue increased 31% in fiscal 2007 compared to fiscal 2006 due to increased maintenance revenue on a growing installed customer base and the renewal of several significant expired maintenance contracts.

Revenue by geography, as a percentage of total revenue, is as follows:

                                     Twelve Months Ended September 30,
                                     2008             2007          2006
               North America               42 %             41 %        43 %
               Europe                      50 %             54 %        50 %
               Asia Pacific                 8 %              5 %         7 %

North America revenue is primarily derived from deployments of our smart card-based software products, such as ActivClient, the ActivIdentity Card Management System and Single Sign On to various departments of the U.S. federal government and our enterprise customers. Revenue in North America has remained relatively flat as a percentage of total revenue over the last three years.

As a percentage of total net revenue, European revenue spiked in fiscal year 2007 on increased demand from government agencies for our Smart Employee identification solutions. The loss of a significant customer in Europe during fiscal year 2007 to consolidation in the banking industry negatively impacted fiscal year 2008 European revenues. Total revenues in Europe were down $2.8 million in fiscal 2008, from 54% to 50% of total revenue, driven primarily by decreased hardware sales.

Asia Pacific sales as a percentage of total revenue increased from 5% in fiscal 2007 (total sales of $3.1 million) to 8% in fiscal 2008 (total sales of $4.9 million), on increased sales revenue of $1.8 million. Software revenue in the Asia Pacific region increased $0.9 million, primarily resulting from increased software revenue in Australia. Hardware revenue increased $0.8 million, with $0.5 million of the increase attributable to hardware sales in Singapore.

Hardware and software revenue (product revenue) by customer category as a percentage of total hardware revenue and software revenue is as follows:

                                  Twelve Months Ended September 30,
                                  2008             2007          2006
                 Enterprise             62 %             55 %        49 %
                 Government             20 %             27 %        28 %
                 Financial              18 %             18 %        23 %

100 % 100 % 100 %

Total product revenue decreased $1.6 million in fiscal 2008 compared to fiscal 2007. Enterprise sector revenue increased $1.2 million for fiscal 2008, driven by increased hardware sales. Financial sector revenue was flat year-over-year. Government sector revenue decreased $2.8 million for fiscal

2008 on weaker hardware sales of $2.3 million and weaker software sales of $0.5 million. Total government sales suffered on general fiscal concerns as spending was curtailed throughout the sector.

Comparing 2007 to 2006, the increase in percentage of revenue from the enterprise sector is mainly due to the strengths seen in the card management business. The financial sector experienced a year over year decrease in percentage of total revenue as a result of a slowdown in the client and authentication business. The governmental sector includes sales to U.S. federal government as well as other domestic and foreign governmental agencies and was relatively flat year over year in terms of percentage of total product revenues.

COST OF REVENUE

    Total cost of revenue, costs as a percentage of corresponding revenue, and
period-over-period changes are as follows (dollars in thousands):

                           Twelve Months Ended                      Twelve Months Ended
                              September 30,         Percentage         September 30,         Percentage
                            2008          2007        Change         2007          2006        Change
Software                  $      963    $  1,303            -26 %  $    1,303    $  1,891            -31 %
As a percentage of
software revenue                   5 %         7 %                          7 %         9 %
Hardware                       9,551       9,036              6 %       9,036       8,541              6 %
As a percentage of
hardware revenue                  63 %        53 %                         53 %        60 %
Service                       10,779       7,267             48 %       7,267       6,616             10 %
As a percentage of
service revenue                   44 %        31 %                         31 %        37 %
Amortization of
acquired developed
technology and patents         2,380       2,949            -19 %       2,949       2,772              6 %

Total cost of revenue     $   23,673    $ 20,555             15 %  $   20,555    $ 19,820              4 %

Cost of software revenue includes the cost of professional services associated with customization essential to the functionality of software. Cost of software revenue was down in fiscal 2008 on a $0.3 million decrease in professional services revenue on customized software arrangements. Margins on customized software deals improved slightly in fiscal 2008 over the prior year. Cost of software revenue decreased in fiscal 2007 on a $0.5 million decrease in professional service revenue on customized software arrangements. Margins on customized software deals improved slightly in 2007 over the prior year.

Cost of hardware revenue includes costs associated with the manufacturing and shipping of product, logistics, operations, warranty costs and charges related to excess and obsolete inventory. Hardware product margins are influenced by numerous factors including hardware product mix, inventory adjustments, pricing, geographic mix and foreign currency exchange rates. Many of these factors influence, or are interrelated with, other factors. As a result, it is difficult to precisely quantify the impact of each item individually to our hardware margins. The majority of our smart card and reader revenue reflects products manufactured for us by original equipment manufacturers that accordingly have lower margins compared to tokens, which are manufactured for us by contract manufacturers and yield higher gross margins.

In 2008, cost of hardware revenue increased $0.5 million as margins were adversely impacted due to competitive pressures, especially in emerging markets in the Asia Pacific sector. In absolute dollars

terms, cost of hardware revenue increased by approximately $0.5 million in 2007 from 2006 as a result of additional inventory cost associated with higher hardware revenue. Margins improved in 2007 mainly as a result of a higher volume of high margin tokens shipped during fiscal year 2007.

Cost of service revenue consists of personnel costs and expenses incurred in providing post-contract customer support and professional services not essential to software such as installation, training, and consulting. Cost of service revenue increased $3.5 million in fiscal 2008. Increased sustaining engineering costs incurred by the development team on a growing installed customer base resulted in a $2.9 million increase in costs over fiscal 2007. Costs associated with providing professional services increased approximately $0.6 million on increased professional service revenue not essential to the functionality of software. The allocation of additional sustaining engineering costs adversely impacted margins.

Absolute cost of service revenue increased in fiscal 2007 over fiscal 2006 on a 31% increase in service revenue. Margins improved year over year as the significant fixed costs associated with providing maintenance and support were spread over an increasing revenue stream from the growing installed customer base.

Amortization of acquired developed technology and patents includes amortization of technology capitalized in our acquisitions and purchase of certain patents and related intellectual property from third parties. Decreases in amortization expense in fiscal 2008 are in line with the scheduled amortization of acquired developed technology and patents, as certain items become fully amortized. On a year over year comparison, there was an increase of $0.2 million between fiscal years 2007 and 2006 related to amortization of a patent acquired in the fourth quarter of fiscal 2006. We expect to amortize approximately $2.2 million related to acquired technology in fiscal 2009.

OPERATING EXPENSES

A substantial proportion of our operating expenses are fixed. Accordingly, a small variation in the timing for recognition of revenue can cause significant variations in operating results across periods.

     Sales and Marketing

    Sales and marketing expenses and period-over-period changes are as follows
(dollars in thousands):

                                                       Twelve Months Ended
                                                          September 30,
                                                   2008        2007        2006
       Sales and marketing                       $ 25,602    $ 25,282    $ 26,889
       Percentage change from comparable prior
       period                                           1 %        -6 %
       As a percentage of total revenue                43 %        42 %        50 %
       Headcount, end of period (includes
       professional services employees)                90         110         107

Sales and marketing expenses consist primarily of salaries and other payroll expenses such as stock-based compensation, commissions, travel, depreciation, costs associated with marketing programs, promotions, trade shows, and allocations of facilities and information technology costs.

Sales and marketing expenses remained relatively flat in fiscal year 2008 from the prior year. Headcount reductions were concentrated in the final half of fiscal 2008 and current year cost savings were offset by increased severance expense.

     Research and Development

    Research and development expenses and period-over-period changes are as
follows (dollars in thousands):

                                                          Twelve Months Ended
                                                             September 30,
                                                       2008       2007       2006
    Research and development                         $ 18,867   $ 19,935   $ 19,560
    Percentage change from comparable prior period         -5 %        2 %
    As a percentage of total revenue                       32 %       33 %       37 %
    Headcount, end of period                              115        137        134

Research and development expenses consist primarily of salaries, costs of components used in research and development activities, travel, depreciation, and allocations of facilities and information technology costs.

During fiscal year 2008, an additional $2.9 million of research and development expenses on sustaining engineering projects were allocated to cost of service revenues. Offsetting this decrease in 2008 research and development expenses were increased spend on outsourced services of $0.4 million, increased severance associated with headcount reduction of $0.8 million, and a weakening U.S. dollar in the first three quarters which increased the cost of expenses incurred in foreign jurisdictions. Over half of our research and development costs are incurred in a currency other than the U.S. dollar.

In fiscal 2007, research and development expense increased by $0.4 million or 2% from fiscal 2006 primarily as a result of costs relating to increased staffing levels, particularly in the United States, of approximately $0.8 million. The higher concentration of employees in the United States also contributed to a higher facilities allocation of approximately $0.3 million. . . .