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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
   FORM 10 - K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the year ended December 31, 2003 Commission File Number 0-11630   TeraForce Technology Corporation  Delaware
    
    76-0471342(State or Other Jurisdiction of
    
    (I.R.S. EmployerIncorporation or Organization)
    
    Identification No.)
 1240 E. Campbell, Richardson, Texas
75081
(Address of Principal Executive Offices and Zip Code) 469-330-4960
(Registrants Telephone Number, Including Area Code)   Securities Registered Pursuant to Section 12 (b) of the ActNone Securities Registered Pursuant to Section 12 (g) of the ActCommon Stock par value $0.01 per share
(Title of Class) Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes
[ü]  No [  ] 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 [  ] Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities and Exchange Act of
1934). Yes [  ] No [ü] The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $35,686,000 as of June 27, 2003 (based upon the
average of the highest bid and lowest asked prices on such date as reported on
the OTC Bulletin Board). All directors, officers and 5% or greater
stockholders are presumed to be affiliates for purposes of this calculation. There were 130,581,648 shares of Common Stock outstanding as of February 29,
2004. DOCUMENTS INCORPORATED
BY REFERENCE




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TABLE OF CONTENTS Section
    
    Page NumberITEM 1 
    
    Business
    
    3ITEM 2 
    
    Properties
    
    17ITEM 3 
    
    Legal Proceedings
    
    17ITEM 4 
    
    Submission of Matters to a Vote of Security Holders
    
    18ITEM 5 
    
    Markets for
Registrants Common Equity and Related Stockholder Matters
    
    19ITEM 6 
    
    Selected Financial Data
    
    20ITEM 7 
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    21ITEM 7A 
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    28ITEM 8 
    
    Financial Statements and Supplementary Data
    
    29ITEM 9 
    
    Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
    
    54ITEM 9A 
    
    Controls and Procedures
    
    54ITEM 10 
    
    Directors and Executive Officers of the Registrant
    
    54ITEM 11 
    
    Executive Compensation
    
    54ITEM 12 
    
    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matter
    
    54ITEM 13 
    
    Certain Relationships and Related Transactions
    
    54ITEM 14 
    
    Principal Accounting Fees and Services
    
    54ITEM 15 
    
    Exhibits, Financial Statement Schedules and Reports on Form 8-K
    
    55Amendment to By-laws of the CompanyRegistration Rights AgreementWarrant for the Purchase of Shares of Common StockWarrant for the Purchase of Shares of Common StockAmended and Restated Stock Incentive PlanNote Modification AgreementSubsidiaries of the RegistrantConsent of Grant Thornton LLPCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification Pursuant to Section 906
 2




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PART I 
 ITEM 1  BUSINESS Forward-Looking Statement The statements in this Annual Report on Form 10-K of TeraForce Technology
Corporation (the Company) regarding future financial and operating
performance and results, and other statements that are not historical facts,
are forward-looking statements, as defined in Section 27A of the Securities Act
of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. We use the words may, expect, anticipate, believe,
continue, estimate, project, intend, designed or other similar
expressions to identify forward-looking statements. You should read statements
that contain such words carefully because they discuss future expectations,
contain projections of results of operations or of our financial condition,
and/or state other forward-looking information. These statements also
involve risks and uncertainties, including, but not limited to:  
    
    events, conditions and financial trends that may affect the
Companys future plans and business strategy,  
    
    results of expectations and estimates as to prospective events, and  
    
    circumstances about which the Company can give no firm assurance. Examples of types of forward-looking statements include statements on
future levels of net revenue and cash flow, new product development, strategic
plans and financing. These forward-looking statements involve risks and
uncertainties that could cause actual results to differ materially from those
projected or anticipated. Factors that might cause a difference include, but
are not limited to:  
    
    general economic conditions in the markets in which the Company operates;  
    
    success in the development and market acceptance of new and existing products;  
    
    dependence on suppliers, third party manufacturers and channels of distribution;  
    
    customer and product concentration;  
    
    fluctuations in customer demand;  
    
    the ability to obtain and maintain access to external sources of capital;  
    
    the ability to control costs;  
    
    U. S. Government budget, procurement and contracting trends;  
    
    overall management of the Companys expansion; and  
    
    other risk factors detailed from time to time in the
Companys filings with the Securities and Exchange Commission. We believe it is important to communicate our expectations of future
performance to our investors. However, events may occur in the future that we
are unable to accurately predict, or that we cannot control. Any
forward-looking statement speaks only as of the date the statement was made,
and the Company undertakes no obligation to update any forward-looking
statement to reflect events or circumstances after the date the statement was
made. Because it is not possible to predict every new factor that may emerge,
forward-looking statements should not be relied upon as a prediction of actual
future financial condition or results. When considering our forward-looking
statements, keep in mind the risk factors and other cautionary statements in
this Annual Report on Form 10-K. The risk factors noted in this section and
other factors noted throughout this Annual Report on Form 10-K provide examples
of risks, uncertainties and events that may cause our actual results to differ
materially from those contained in any forward-looking statement. If one or
more of these risks or uncertainties materialize, or if underlying assumptions
prove incorrect, actual outcomes may vary materially from those forward-looking
statements included in this Annual Report on Form 10-K. The terms we, our
and us and similar terms refer to the Company and its consolidated
subsidiaries, not to any individual or group of individuals. 3




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Available Information Our website address is www.teraforcetechnology.com. You may obtain free
electronic copies of our annual reports on Form 10-K, quarterly reports on Form
10-Q, current reports on Form 8-K, and all amendments to those reports in the
Investor Relations section of our website. These reports are available on our
website as soon as reasonably practicable after we electronically file them
with the SEC. Overview TeraForce Technology Corporation, through its wholly-owned subsidiary, DNA
Computing Solutions, Inc. (DCS), designs, develops, produces and sells
high-density, high-capacity embedded computing platforms and systems. Embedded
computing generally refers to the physical integration of computing nodes
(microprocessor and memory) into a host system or application. These nodes are
often deployed in arrays. Embedded computing platforms and systems are widely
applied in a number of industries including communications, medical imaging,
seismic processing, industrial control, homeland security and defense
electronics. Although we have sold these products into a number of these
industries, our primary focus is in defense electronics and homeland security;
therefore, we refer to this collectively as our Defense Electronics business.
Prior to 2001 this business was referred to as the digital signal processor
(DSP) business. Subsequent to 2001, all of our net revenues relate to the
Defense Electronics business. Prior to 2002, we were also involved in providing design engineering
services through a wholly-owned subsidiary, DNA Enterprises, Inc. (DNA), and
in designing and producing telecommunications equipment through other
wholly-owned subsidiaries. (For more information see Item 1- Business- Prior
Operations and Note 16 to our Consolidated Financial Statements). We sell our
products both in the United States and internationally. See Note 16 to our
Consolidated Financial Statements for more information. Products Embedded computing products, such as ours, are used for applications in
which there is a need for high-density and high-capacity computing, especially
in environments where limiting space, weight and power consumption are
important considerations. Examples of defense and homeland security
applications that utilize embedded computing products include the following:  
    
    Airborne radar
    
    Signal intelligence
    
    Unmanned aerial vehicles (UAVs)
    
    Automated fire control
    
    Airborne surveillance
    
    Electronic countermeasures
    
    Ship based radar
    
    Submarine based sonar
    
    Ground based radar
    
    Image processing
    
    Smart munitions
    
    Battlefield control
    
    Satellite communications
    
    Infrared search and tracking
    
    Ship based sonar
    
    Missile interception Our products are organized in the following broad categories: DSP Products  DSP products consist of single-board computers utilizing
digital signal processors produced by Texas Instruments Inc. These products
are produced in versions with one, two or four digital signal processors per
board. The boards include both VME and PCI versions, which are industry
standard terms and describe the manner in which electronic systems
interconnect. PowerPC Single Board Computers  PowerPC Single Board Computer products
are VME single board computers with one, two or four processors per board. The
microprocessors used in these products are the
PowerPC© line of reduced
instruction set, or RISC, processors. We also offer ruggedized versions of
some of these products. Ruggedized products have been mechanically modified
to withstand 4




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harsh operating environments such as temperature, shock and vibration. We call
our primary product line of these products the VQG4. Embedded Sub-Systems  Embedded Sub-Systems are products that comprise an
entire element of a larger system. These elements may include a number of
single board computers, deployed in arrays, as well as other system components
and enclosures. In 2003 we introduced the Eagle I product line. The Eagle
products are designed for use as elements in embedded sub-systems. Eagle is
based on the Companys Matched Heterogeneous Array Topology (MHAT)
technology. WingSpan Software Suite  WingSpan is software that we offer with our
products in order to enhance functionality and to facilitate the customers
development process. WingSpan is a suite of software that includes (a) a board
support package to facilitate testing and integration into the operating
system, (b) a library of commonly used algorithms that have been optimized for
our products and (c) tools to facilitate the development of application
software or the porting of existing software to our products. We generally do
not sell WingSpan separately from our hardware products. We do not supply the
application software to be utilized on our products. The application software
is generally designed to operate under certain commercially available operating
systems, most often VxWorks or Linux. Our products are generally offered in
versions that will support either of these two operating systems, as well as
certain others. Sales of our products are generally not seasonal in nature. In 2003 four
customers, Pentek Inc., L-3 Communications, Progeny Systems and an agency of a
foreign government, each accounted for more than 10% of our consolidated net
revenues. The loss of any of these customers could have a material adverse
effect on our business. As of February 29, 2004, our backlog of orders for Defense Electronic
products amounted to approximately $2,200,000, as compared to approximately
$1,600,000 at February 28, 2003. We include in our backlog orders for products
for which we have received a purchase order or similar commitment from the
customer. Generally, purchase orders are received for products that are to
ship within a relatively short period of time, usually 60 days or less.
Essentially all of the backlog as of February 29, 2004 is scheduled to be
shipped during 2004. We consider the backlog to be an indicator, but not the
sole predictor, of future revenue. A variety of conditions, both specific to
the individual customer and generally affecting the customers industry, may
cause our customers to cancel, reduce or delay orders that were previously made
or anticipated. We cannot assure the timely replacement of canceled, delayed
or reduced orders. Significant or numerous cancellations, reductions or delays
in orders by a customer or group of customers could materially adversely affect
our business, financial condition and results of operations. Our backlog alone
should not be relied upon as indicative of our revenues for any future period. Recent Developments In November 2003, we entered into a Technology License and Marketing
Agreement with VISTA Controls, Inc. (Vista), a subsidiary of Curtiss-Wright
Corporation (Curtiss-Wright). Pursuant to this agreement, and certain
ancillary agreements, we have licensed to Vista technology related to the
Companys VQG4 and Eagle I products (See Item 1 Business  Products). Vista
and we have agreed to jointly develop and market variations of these products,
which will be designed to meet the requirements of harsh operating
environments, also know as rugged products. Vista will produce the rugged
versions of the VQG4 and Eagle I products. For such products that we sell, we
will source the products from Vista at prices determined by a formula specified
in the agreements. For products sold by Vista to third parties, Vista will pay
us residual rights fees pursuant to a formula specified in the agreements. In
addition, Vista will pay license and transfer fees to us aggregating up to
$3,500,000. These fees will be paid as certain milestones that are specified
in the agreements are met. As of February 29, 2004 we have received payments
from VISTA aggregating $1,550,000. We believe the arrangement with VISTA will increase our market
opportunities because we will have additional products to sell and access to
additional marketing channels through VISTA and Curtiss-Wright. 5




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In February 2004, Curtiss-Wright acquired one of our competitors, DY4 Systems
(See Item 1- Business  Competition). We believe that this transaction will
enhance Curtiss-Wright and VISTAs market channels and therefore will also
increase our market opportunities. Markets and Customers Our customers are usually large prime defense contractors and
subcontractors to the prime defense contractors. We also sell directly to
governmental agencies and to value added resellers who combine our products
with other system components for re-sale to the prime or subcontractors.
Certain of our DSP products are sold through an OEM arrangement with a
reseller. Our sales to this reseller amounted to approximately 19% of our
consolidated net revenues for the year ended December 31, 2003. Three other
customers accounted for approximately 18%, 16% and 11%, respectively, of our
consolidated net revenues in 2003. Our sales and marketing activities are directed by in-house sales
managers. We also utilize a network of manufacturers representatives in the
United States to sell our products. International sales amounted to
approximately 11% of our consolidated net revenues in 2003. The selection of our products by a customer for use in a particular
application, system or program is referred to as a design win. The sales
cycle leading to a design win will often take a long time. Most often we will
initially sell a limited number of units for testing and evaluation purposes.
Sometimes we will provide a customer with a demonstration unit that they may
evaluate and test. After the evaluation period ends, the customer will either
return the unit or purchase it. If the customer determines that the initial
evaluation is satisfactory, the customer will often purchase a number of units
to use in the design, development and testing of the customers larger system. Even after a customer has elected to utilize our product, the customer
will not usually purchase a significant number of units immediately. Although
the production phase of a particular program may last several years and

ultimately involve a significant number of units, at any one time the customer
will usually only purchase the units it will need for a short period of time.
There are still a number of factors that will determine whether the customer
purchases a significant number of products, and when these products are
purchased. These factors include:  
    
    the suitability of our products for a particular application, including performance and cost issues;  
    
    the technical performance of the final system;  
    
    the customers ability to fund the final system;  
    
    the performance of the customers other suppliers for the final system; and  
    
    the overall development and integration of the system by the customer. Sales are typically not made under long-term contracts, but are made under
purchase orders. Historically, products similar to ours were often developed internally by
the large defense contractors. However, beginning in the mid-1990s the
Department of Defense implemented a program to force the contractors to utilize
commercial off the shelf (COTS) components wherever possible. This has
fueled the growth in the Companys markets, and we anticipate that this growth
will continue. We expect the growth in the COTS market to continue as legacy
systems that were developed years ago are upgraded or replaced with new systems
with significant COTS content. Competition The market for our products is highly competitive and is characterized by
rapidly changing technology and frequent product performance improvements. We
have an number of competitors s in the defense electronics market, including
Mercury Computer Systems, Inc., Radstone Technology, PLC, CSPI Multi Computer
Division of CSP Inc., and DY4 Systems, previously a Force Computer business
unit (see 6




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Item 1- Business  Recent Developments). Our competitors also include
in-house design teams of large defense contractors. However, competition from
in house design teams has diminished in recent years because of the increased
use of COTS products and the trend toward greater use of outsourcing. Despite
this recent change, there can be no assurance that in house developments will
not return as a major competitive force in the future. Increased use of in
house design teams by defense contractors may have a material adverse effect on
our business, financial condition and results of operations. All of the large defense contractors and a majority of our other
competitors have substantially greater research and development resources,
guaranteed long term supply capacity, marketing and financial resources,
manufacturing capability and customer support organizations than we have. We
believe our future ability to compete effectively will depend upon our ability
to continue to improve product and process technologies, to develop new
technologies that demonstrate performance advantages over our competitors, to
adapt products and processes to changes in technology, to identify and adopt
emerging industry standards and to adapt to our customers needs. Most of our competitors have greater financial and other resources than we
have. We may be operating at a cost disadvantage compared to those
manufacturers who have greater direct buying power from component suppliers or
who have lower cost structures. There can be no assurance that we will be able
to compete successfully in the future with any of these competitors. In
addition, there can be no assurance that competitive pressures will not result
in price erosion, reduced margins, loss of market share or other factors that
could have a material adverse effect on our business, financial condition and
results of operations. Manufacturing We use third party electronic manufacturing service (EMS) providers to
manufacture our products. Generally, we will acquire the components necessary
for the manufacture of the product and provide the components to the EMS
provider for assembly and initial testing. Completed units are normally then
delivered to our facility in Richardson, Texas for final testing and shipment.
Recently, we have shifted more of the product testing to the EMS providers. We
expect to rely more on the EMS provider for product testing. We expect that
moving the initial product testing to the EMS provider will allow us to use our
existing operations infrastructure to produce higher sales volumes. We also
expect that as production volumes increase and can be more accurately
predicted, the EMS providers will buy many of the components required for our
products, which will allow us to use our resources in other ways. We normally use a particular EMS provider for a specific product family.
A number of EMS providers are capable of producing our products; however,
switching from one provider to another involves significant costs and risks
related to product quality and timing. As a result of our recent agreement with VISTA, we will procure the
ruggedized versions of the VQG4 and Eagle I products from VISTA. VISTA will
arrange for the manufacture of these products. Components are usually available from multiple sources. However, items
such as processors and memory chips may be available from limited or sole
sources. Historically, we have had to order some components a significant time
in advance of the date we plan to use the components. Sometimes components may
be discontinued by the manufacturer, requiring us to acquire a substantial
supply or to alter our product design. These design changes can render
components in our inventory obsolete. Intellectual Property and Other Proprietary Rights We believe that we have a substantial base of intellectual property,
including software and hardware. Factors such as technological and creative
skills of our personnel, new product developments, frequent product
enhancements, name recognition, and reliable product manufacturing are
essential to our ability to establish and maintain a technology leadership
position. 7




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We rely on a combination of patent, copyright, trademark and trade secret
laws to establish and protect our products proprietary rights. In addition,
we currently require our employees and consultants to enter into nondisclosure
and assignment of invention agreements to limit the use of, access to and
distribution of our proprietary information. There can be no assurance that
our means of protecting our proprietary rights in the U.S. or abroad will be
adequate. The laws of some foreign countries may not protect our proprietary
rights as fully or in the same manner as do the laws of the U.S. Also, despite
the steps we take to protect our proprietary rights, it may be possible for
unauthorized third parties to copy or reverse engineer aspects of our products,
develop similar technology independently or otherwise obtain and use
information that we regard as proprietary. There can be no assurance that
others will not develop technologies similar or superior to our technology or
design around the proprietary rights we own. Although we are not aware that our products infringe on the proprietary
rights of third parties, there can be no assurance that others will not assert
claims of infringement against us in the future, or that, if made, such claims
will not be successful. We may seek to obtain a license under a third partys
intellectual property rights. There can be no assurance that a license will be
available under commercially reasonable terms or that a license will be
available at all. Any claims against us that result in litigation, whether or not such
litigation is determined in favor of the Company, could result in significant
expense to us and divert the efforts of our technical and management personnel
from daily operations. Any adverse ruling regarding intellectual property may
require us to pay substantial damages, discontinue the sale of infringing
products, expend significant resources to develop non-infringing technology or
obtain licenses to use infringing or substituted technology. The failure to
develop, or license on acceptable terms, a substitute technology could have a
material adverse effect on our business, financial condition and results of
operations. Litigation may also be necessary to enforce our patents and other
intellectual property rights, to protect our trade secrets, and to determine
the validity of and scope of the proprietary rights of others. Such litigation
could result in substantial costs and diversion of resources and could have a
material adverse effect on our business, financial condition or results of
operations. We currently hold 17 United States patents relating to telecommunications
and computing technology and have 11 currently pending patents relating to
telecommunications and computing technology. None of our patents will expire in
the near future. We seek to protect our software, documentation and other
written materials under trade secret and copyright laws, which afford only
limited protection. Patent positions frequently are uncertain and involve
complex and evolving legal and factual questions. The coverage sought in a
patent application may be denied or significantly reduced before or after the
patent is issued. There can be no assurance that:  
    
    any patents from pending patent applications or from any
future patent application will be issued,  
    
    the scope of any patent protection will exclude competitors
or provide competitive advantages to us,  
    
    any of our patents will be held valid if subsequently challenged, or  
    
    others will not claim rights in or ownership of the patents and other proprietary rights held by us. Because publication of discoveries in the scientific or patent literature
often lags behind actual discoveries, we cannot be certain that we were the
first to make the inventions covered by each of our pending patent applications
or that we were the first to file patent applications for such inventions. In
addition, there can be no assurance that competitors, many of whom have
substantial resources and have made substantial investments in competing
technologies, will not seek to apply for and obtain patents that will prevent,
limit or interfere with our ability to make, use or sell our products either in
the United States or in international markets. 8




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Employees As of February 29, 2004 we had 42 full-time employees, of which fourteen
were engaged in engineering and development, 9 were engaged in sales,
marketing, and customer support, 9 were engaged in manufacturing operations,
and 10 were engaged in administration and finance. None of our employees are
represented by a labor organization. We have not experienced any material work
stoppages and believe we have a good relationship with our employees. Prior Operations Our name was changed to TeraForce Technology Corporation on January 30,
2001, from Intelect Communications, Inc. The Company was incorporated in
Delaware on May 23, 1995. Its predecessor, Intelect Communications Systems
Limited (Intelect (Bermuda)) was incorporated under the laws of Bermuda in
April 1980 and operated under the name Coastal International, Ltd. until
September 1985 and as Challenger International Ltd. until December 1995. On
December 4, 1997, the shareholders of Intelect (Bermuda) approved a merger
proposal that reincorporated Intelect (Bermuda) in Delaware and resulted in
Intelect (Bermuda) becoming a publicly traded corporation. The merger was
effected on December 4, 1997. Engineering Design Services Our engineering design services business was conducted through DNA, a
20-year old engineering design services organization located in Richardson,
Texas that we acquired in 1996. Over its history DNA provided high-end
engineering design services to both established companies and start-up
organizations, primarily related to the telecommunications industry. During
the course of 2001, DNA experienced a significant decline in the demand for its
services. This was caused by the continued down-turn and uncertainty in the
telecommunications business and the financing difficulties experienced by many
start-up organizations. We determined that there was no longer adequate
justification to continue to fund the costs associated with maintaining the DNA
organization in light of the uncertainty in future demand for its services.
Therefore, as of December 31, 2001 we commenced a plan to dispose of this
business and on January 11, 2002 sold substantially all of the assets related
to the design services business to Flextronics International, Ltd.
(Flextronics). The operations related to the engineering design services
business are treated as discontinued operations in the accompanying
consolidated financial statements. (See Note 4 of the Notes to Consolidated
Financial Statements  included in Item 8  Financial Statements and
Supplementary Data.) Effective with the sale of substantially all the assets of DNA to
Flextronics we no longer provide contract engineering design services. These
services had been provided on a time and material basis and the customer
retained all rights to the developed intellectual property. Telecommunications Equipment Prior to 2001, a major focus of our business was the development, design,
production and sale of optical networking equipment for application in
telecommunication networks. We had specifically focused on our OmniLynx
product line. The business related to OmniLynx, and predecessor products
SonetLynx© and FibreTrax©, was conducted through a wholly-owned subsidiary,
Intelect Network Technologies Company (INT). During 2000, opportunities in
the telecommunications market began to decline dramatically. As a result of
this, we determined that the long-term strategic value of the OmniLynx product
line was not as promising as the Companys other businesses and implemented a
plan to materially curtail the operations of INT and to sell INT or
substantially all of the assets related to the OmniLynx product line. In
February 2001, a potential sale of the OmniLynx business to a company in the
United Kingdom did not materialize, and we terminated the majority of the
employees of INT. In August 2001, we completed a sale of the OmniLynx product
line and substantially all of the related assets to a newly formed entity,
Intelect Technologies, Inc. (ITI). ITI is a corporation initially owned 67%
by Singapore Technology Electronics, Ltd. (STE) and 33% by the Company. In
February 2003, STE made an additional investment in ITI 9




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increasing its ownership to approximately 78% and decreasing our ownership
to approximately 22%. ITI is continuing with the active production and sale of
the OmniLynx product line, primarily for use in purpose-built network
applications such as highway systems, rail systems, airport communication
systems and pipeline networks. We have minority representation in ITIs board
of directors and have no involvement in day-to-day operations. We account for
our investment in ITI using the equity method of accounting. In October 2003,
we reached an agreement in principle to dispose of our interest in ITI and to
settle all outstanding obligations between the Company and ITI for a cash
payment to us of $250,000. Accordingly, the carrying value of our investment
in ITI has been written-down to $250,000 and the carrying value of the our
receivable from ITI has been adjusted to zero. The loss from these adjustments
was $1,151,000. (See Note 6 of the Notes to Consolidated Financial Statements
 included in Item 8  Financial Statements and Supplementary Data.) During 2001, we continued development activities on a new generation of
optical networking equipment through another wholly-owned subsidiary, Aegean
Networks, Incorporated (Aegean). We funded all development activities, but
had sought strategic investors to provide funding in order to allow full-scale
development. We had received indications of interest from a number of
potential strategic investors, but the uncertainties surrounding the recovery
of markets for telecommunications equipment and other economic factors resulted
in no firm commitments to provide funding for Aegean. In the fourth quarter of
2001 we curtailed development activities related to Aegean and in the second
quarter of 2002 ceased all development activity related to Aegean. During 2001, we launched development activities related to a line of
products to provide high-density, telecommunications-grade solutions to the
Internet server and storage markets. These activities were conducted through a
wholly-owned subsidiary, Centauri NetSystems Corporation (Centauri).
Economic and industry conditions made obtaining third party financing for this
project difficult and in March 2002 we suspended all development activity
related to the Centauri project. See
Item 7 - Managements Discussion and Analysis of Financial Condition
and Results of Operations for a discussion of research and development
expenditures over the past three years. See Note 16 of the Notes to
Consolidated Financial Statements  included in Item 8  Financial Statements
and Supplementary Data- for information regarding revenue and profits by
segment and geographic region. Risk Factors In addition to the other information in this Annual Report on Form 10-K,
the following are risk factors that should be considered in evaluating the
Company and an investment in our common stock. The trading price of the common
stock could decline due to any of these risks, and investors in our common
stock could lose all or part of their investment. RISK FACTORS RELATED TO OUR BUSINESS A Number of Factors Could Cause Operating Results to Fluctuate
Significantly. Our revenues and operating results in any reporting period may fluctuate
significantly due to a variety of factors, including:  
    
    changes in the price or availability of components for our products;  
    
    the mix of products sold to the defense electronics markets and other markets;  
    
    our ability to introduce new technologies and features ahead of competitors;  
    
    the timing and size of orders we receive from customers;  
    
    fluctuations in demand for our products;  
    
    delays in testing and evaluation by customers;  
    
    production delays due to quality problems with or availability of components;  
    
    changes in our pricing policies or the pricing policies of our competitors; 10




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
    
    changes in customers requirements, including changes or cancellations of orders from customers;  
    
    manufacturing and shipment delays and deferrals;  
    
    our ability to efficiently produce and ship orders promptly on a price-competitive basis;  
    
    announcements or introductions of new products by our competitors;  
    
    changes in U.S. Government budget, procurement and contracting trends; and  
    
    changes in general economic conditions as well as those specific to the defense electronics industry. Current economic conditions have made it more difficult to make reliable
estimates of future revenues. Fluctuations in our revenue can lead to greater
fluctuations in our operating profits. In addition, we expect to incur
significant research and development expenses as we develop products to serve
our markets, all of which are subject to rapidly changing technology, frequent
product performance improvements and evolving industry standards. The ability
to deliver superior technological performance on a timely and cost effective
basis is a critical factor in securing design wins for future generations of
defense electronics systems. Significant research and development spending by
the Company does not ensure that our products will be designed into a
customers system. Because future production orders are usually contingent
upon securing a design win, our operating results may fluctuate due to either
obtaining or failing to obtain design wins for significant customer systems. We Have Incurred Significant Losses in the Past and Are Not Currently
Profitable. We are not currently profitable. In 2003, 2002 and 2001 we have incurred
net losses of $8,559,000, $4,350,000, and $21,549,000, respectively. These
losses have been funded from borrowings under credit facilities and sales of
debt and equity securities. It is not certain when we will become profitable.
The ability to become profitable will depend, in part, on our ability to
increase net revenue from sales of defense electronics products. If our need
for capital exceeds available resources, there can be no assurance that
additional capital will be available through public or private equity or debt
financing. Debt Service Obligations May Adversely Affect Our Cash Flow and We May Be
Unable to Repay the Debt On Time. We have approximately $7,400,000 of debt outstanding. Of this amount,
approximately $700,000 is due by December 31, 2004 and the balance is due by
June 30, 2005. We may not be able to generate sufficient cash flow from
operations to repay all of this debt when it comes due. Approximately
$3,120,000 of this debt is convertible into common stock at the option of the
holder at a rate of $0.16 per share, which is less than prices at which our
stock has recently traded. Therefore, this debt may be converted into common
stock before its maturity. We intend to restructure or refinance any balance of
the debt if we are not able to repay it when it comes due. However, there is no
assurance that the convertible debt will be converted into common or that we
will be able to restructure or refinance the remaining debt in a timely manner.
Even if we are able to refinance or restructure this debt, we may still be
subject to substantial interest and principal repayment obligations. Our Auditors Have Expressed Doubt as to Our Ability to Continue as a Going
Concern. Our independent certified public accountants have added an explanatory
paragraph to their audit opinion issued in connection with our consolidated
financial statements. The opinion states that our ability to continue as a
going concern is uncertain due to our history of operating losses and difficulty in generating operating cash flows. Our
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty. These adjustments might include
changes in the possible future recoverability and classification of assets or
the amounts and classification of liabilities that might result from the
outcome of this uncertainty. 11




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We May Not Be Able to Successfully Complete Development and Achieve
Customer Acceptance of New Defense Electronics Products. We must continually enhance our products and develop new products on a
timely and cost effective basis. Certain enhancements to our products are in
the development phase and are not yet ready for commercial manufacturing or
deployment. The successful development and deployment of these products is
subject to substantial risk. The development of these products, from
laboratory prototype to customer trial, and subsequently to general
availability, involves a number of steps including the following:  
    
    completion of product development;  
    
    the qualification and multiple sourcing of critical components;  
    
    validation of manufacturing methods and processes;  
    
    extensive quality assurance and reliability testing, and staffing of testing infrastructure;  
    
    validation of embedded software; and  
    
    establishment of systems integration and systems test validation requirements. Each of these steps in turn presents serious risks of failure, rework or
delay. Any one of these setbacks could decrease the speed and scope of product
introduction and marketplace acceptance of the product. In addition,
unexpected intellectual property disputes, failure of critical design elements,
and other setbacks may delay or even prevent the introduction of these
products. A lack of working capital may also negatively impact our ability to
enhance our products in a timely manner. Additionally, the markets for our new products may be undeveloped. The
commercial acceptance of these types of products is uncertain. We cannot
assure you that our sales and marketing efforts for these products will be
successful. We are a Party to Lawsuits and May Be Subject to Other Contingent
Liabilities. We are a named party in a lawsuit and may be subject to significant other
contingent liabilities. Defending these matters may require a substantial
amount of our resources, and any judgments may materially affect our financial
condition and results of operations. For more information see Item 3  Legal
Proceedings. Our Failure to Quickly Adopt to Rapidly Changing Competitive and Economic
Conditions Could Have a Material Adverse Effect on Our Business and Results of
Operations. We operate in a rapidly changing and competitive and economic environment.
Our future success will depend, in part, on our ability to enhance our current
products and to develop new products on a timely and cost-effective basis that
respond to technological developments and changing customer needs. The markets
for sophisticated technology are constantly undergoing rapid competitive and
economic changes. The full scope and nature of these changes are difficult to
predict. The defense electronics market, in particular, demands constant
technological improvements as a means of gaining military advantage. We
believe that technological change will continue to attract new entrants to our
market. Industry consolidation among competitors may increase their financial
resources, which may allow our competitors to reduce their prices. This would
require us to reduce the prices of our products or risk losing market share. We Have a Limited Customer Base. We are dependent on a small number of customers for a large portion of our
revenues. In 2003, four customers accounted for approximately 64% of our net
revenues. Customers in the defense electronics market purchase our products in
connection with government programs that may have limited duration, leading to
fluctuating sales to any particular customer in the defense electronics market
from year to year. A significant decrease in our sales to any of our major
customers, or the loss of any of our major customers, would have a material
adverse effect on our business, financial condition and results of operations.
In addition, our revenues are largely dependent upon the ability of our customers
to develop and sell products 12




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and systems that incorporate our products. There
is no assurance that our customers will not experience financial or other
difficulties that could adversely affect our operations and, in turn, our
results of operations. We May Not Be Successful if We Do Not Attract New Customers. Our future success will depend on our attracting additional customers.
The growth of our customer base could be adversely affected by:  
    
    customer unwillingness to implement our defense electronics
technology;  
    
    any delays or difficulties that we may incur in completing
the development, introduction and production manufacturing of our
planned products or product enhancements;  
    
    new product introductions by our competitors;  
    
    any failure of our products to perform as expected;  
    
    any difficulty we may incur in meeting customers delivery,
installation or performance requirements; or  
    
    customer concerns over our financial condition. We Must Attract, Retain and Motivate Key Technical and Management
Personnel in a Competitive Market in Order to Sustain and Grow Our Business. Our success depends to a significant extent upon key technical and
management employees. Competition for highly qualified employees can be
intense and the process of locating key technical and management personnel with
the required combination of skills and attributes can be lengthy and expensive.
There can be no assurance that we will be successful in retaining our existing
key personnel or in attracting and retaining the additional employees we may
require. We must continue to recruit, train, assimilate, motivate, and retain
qualified managers and employees to manage our operations effectively. If we
do not successfully recruit, hire and retain key employees, we may be unable to
execute our business plan effectively and our results of operations could be
significantly adversely affected. Our Agreement with VISTA May Not Produce the Expected Benefits. We expect that our relationship with VISTA will have a positive effect on
our business because of new products we expect to have as a result of the
relationship and access to VISTAs market channels. There is no assurance that
these benefits will materialize. The joint development of the new products and
customer acceptance of those products is subject to the same risks and
uncertainties as we have described above. Even if we are able to utilize
VISTAs market channels, there is no assurance that this will result in
material increased net revenues or that the margins generated from any such
increase will be significant. The agreement with VISTA could prevent us from
pursuing other opportunities. We May Be Unable to Secure Necessary Components and Support Because We
Depend Upon a Limited Number of Third-Party Manufacturers and Support
Organizations. We depend on a limited number of suppliers for components of our products,
as well as for equipment used to design and test our products. Certain
components used in our products are only available from a single source or
limited number of vendors. If these suppliers were to limit or reduce the sale
of such components to the Company, or if these suppliers were to experience
financial difficulties or other problems that prevented them from supplying the
Company with the necessary components, such events could have a material
adverse effect on the Companys business, financial condition and results of
operations. These sole source and other suppliers are each subject to quality
and performance issues, materials shortages, excess demand, reduction in
capacity and other factors that may disrupt the flow of goods to the Company or
its customers; thereby adversely affecting the Companys business and customer
relationships. Some of the sole source and limited source vendors are companies
who, from time to time, allocate parts to equipment manufacturers due to market
demand for components and equipment. The Company has no guaranteed supply
arrangements with its suppliers and there can be no assurance that its
suppliers will continue to meet the Companys requirements. Many of our competitors are much larger and may be
able to obtain priority 13




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allocations from these shared vendors, thereby limiting
or making our sources of supply unreliable for these components. If the
Companys supply arrangements are interrupted, there can be no assurance that
the Company would be able to find another supplier on a timely or satisfactory
basis. Any delay in component availability for any of our products could
result in delays in deployment of these products and in our ability to
recognize revenues. Suppliers may be concerned regarding our financial
condition and therefore may be unwilling to sell components to us, or to grant
trade credit to us. If we are unable to obtain a sufficient supply of components from
alternative sources, reduced supplies and higher prices of components will
significantly limit our ability to meet scheduled product deliveries to
customers. A delay in receiving certain components or the inability to receive
certain components could harm our customer relationships and our results of
operations. Failures of components affect the reliability and performance of our
products, can reduce customer confidence in our products, and may adversely
affect our financial performance. From time to time, we have experienced
delays in receipt of components and have received components that do not
perform according to their specifications. Any future difficulty in obtaining
sufficient and timely delivery of components could result in delays or
reductions in product shipments that could harm our business. In addition, a
consolidation among suppliers of these components or adverse developments in
their businesses that affect their ability to meet our supply demands could
adversely impact the availability of components that we depend on. Delayed
deliveries from these sources could adversely affect our business. Our defense electronics products are manufactured by a limited number of
third-party manufacturers. If we were required to find alternative third-party
manufacturers, we may be forced to incur significant costs and risks. There is
no assurance that the alternative manufacturers could produce our products with
quality or costs comparable to the existing manufacturers. In addition, the
transfer of the manufacturing process to an alternative provider could result
in significant delays that could cause us to miss deadlines imposed by our
customers. The Defense Electronics Products Business Is Subject to Special Risks. We expect that the majority of our net revenues in the future will come
from the sale of our defense electronics products. We supply products to
sub-contractors and prime contractors whose ultimate customer is often an
agency of the United States government. The funding of U.S. government
programs is subject to congressional appropriations. Although multiple-year
contracts may be planned in connection with major procurements, Congress
generally appropriates funds on a fiscal year basis even though a program may
continue for several years. Consequently, programs are often only partially
funded initially, and additional funds are committed only as Congress makes
further appropriations and prime contracts receive such funding. The U.S.
government could reduce or terminate a prime contract under which the Company
is a subcontractor or team member irrespective of the quality of our products
or services. The reduction in funding or termination of a government program
we are involved in would result in a loss of anticipated future revenues
attributable to that program and contracts or orders received by the Company.
The termination of a program or the reduction in or failure to commit
additional funds to a program the Company is involved in could increase our
overall costs of doing business and have a material adverse effect on our
financial condition and results of operations. The contracts with the United
States government are subject to special risks including the following: delays
or cancellations of funding for programs; ability of the government to
unilaterally cancel the contract; reduction or modification as a result of
budgetary restraints or political changes; and other factors not under the
control of us or the prime contractor. In addition, changes in government
administration, and changes in national and international priorities including
developments in the geo-political environment such as the current War on
Terrorism, Operation Enduring Freedom, Operation Iraqi Freedom, and nuclear
proliferation in North Korea, could have a significant impact on defense
spending priorities and the efficient handling of routine contractual matters.
These changes could have either a positive or negative impact on our business,
financial condition or results from operations in the future. 14




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The Failure to Develop and Introduce New Products That Meet Changing
Customer Requirements and Address Technological Advances Would Limit Our
Ability to Sell Our Products and Services. New product development often requires long-term forecasting of market
trends, and development and implementation of new technologies. If we fail or
are late to respond to new technological developments, market acceptance of our
products may be significantly reduced or delayed. The markets we participate
in are characterized by rapidly changing technology, evolving industry
standards, changes in end user requirements, and frequent new product
introductions and enhancements. The introduction of products embodying new
technologies or the emergence of new industry standards can render our existing
products obsolete or unmarketable. There can be no assurance that we will be
able to develop and introduce new products ahead of our competitors, or that
our products will not be rendered obsolete. If we fail to invest sufficiently
in research and development, our products could become less attractive to
potential customers, and our business and financial condition could be
materially adversely affected. We May Not Be Able to Secure an Adequate Number of Design Wins. Before buying our products, a customer will evaluate our products, and
those of our competitors, as a part of designing a larger system. When a
product is selected by a customer to be utilized in its system we refer to it
as a design win. The design-win process is typically lengthy and expensive,
and there can be no assurance that we will be able to continue to meet the
product specifications of our customers in a timely and adequate manner. In
the defense electronics market, military planners have historically funded
significantly more design projects than actual deployments of new equipment.
There can be no assurance that we will secure an adequate number of design
wins. Failure to secure future design wins could have a material adverse
effect on our business, financial condition and results of operations. Product Performance Problems Could Limit Sales Prospects. The production of new products with high technology content involves
occasional problems while the technology and manufacturing methods mature. If
significant reliability or quality problems develop, including those due to
faulty components, a number of negative effects on our business could result,
including:  
    
    costs associated with reworking the manufacturing processes;  
    
    high service and warranty expenses;  
    
    high inventory obsolescence expense;  
    
    high levels of product returns;  
    
    delays in collecting accounts receivable;  
    
    reduced orders from existing customers; and  
    
    declining interest from potential customers. Although we maintain accruals for product warranties, actual costs could
exceed these amounts. From time to time, there will be interruptions or delays
in the activation of products at a customers site. These interruptions or
delays may result from product performance problems or from aspects of the
installation and activation activities, some of which are outside our control.
If we experience significant interruptions or delays that cannot be promptly
resolved, confidence in our products could be undermined, which could have a
material adverse effect on operations. Failure to Protect Our Intellectual Property Could Adversely Affect Our
Ability to Compete in the Industry and Our Profitability. We rely on a combination of patents, copyright, trademark and trade secret
laws, and restrictions on disclosure to protect our intellectual property. We
also enter into confidentiality or license agreements with our employees,
consultants and corporate partners and control access to and distribution of
our software, documentation and other proprietary information. These
intellectual property protection measures may not be sufficient to prevent
wrongful misappropriation of our technology. In addition, these measures will
not 15




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prevent competitors from independently developing technologies that are
substantially equivalent or superior to our technology. The laws of many
foreign countries do not protect intellectual property rights to the same
extent as the laws of the United States. Failure to protect proprietary
information could result in, among other things, loss of competitive advantage,
loss of customer orders and decreased revenues. Monitoring the unauthorized
use of our products is difficult and we cannot be certain that the steps we
have taken will prevent unauthorized use of our technology, particularly in
foreign countries where the laws may not protect our proprietary rights as
fully as in the United States. If competitors are able to use our technology,
our ability to compete effectively could be impaired. This litigation could
result in substantial costs and diversion of resources and may not ultimately
be successful. We May Be Subject to Intellectual Property Infringement Claims That Are
Costly to Defend and Could Limit Our Ability to Use Some Technologies in the
Future. Like other participants in our industry, we may be subject to infringement
claims and other intellectual property disputes as competition in the
marketplace continues to intensify. In the future, we may be subject to
litigation and may be required to defend against claimed infringements of the
rights of others or to determine the scope and validity of the proprietary
rights of others. Any such litigation could be costly and divert managements
attention from operations. In addition, adverse determinations in such
litigation could:  
    
    result in the loss of our proprietary rights to use the technology;
    
    subject us to significant liabilities;
    
    require us to seek licenses from third parties;
    
    require us to redesign the products that use the technology; or
    
    prevent manufacturing or sale of our products that employ the technology. If we are forced to take any of the foregoing actions, our business may be
seriously harmed. We May Be Unable to License Third-Party Technology at a Reasonable Cost. From time to time we may be required to license technology from third
parties to develop new products or product enhancements. We cannot ensure that
third-party licenses will be available to us on commercially reasonable terms.
The inability to obtain any third-party license required to develop new
products and product enhancements could require us to obtain substitute
technology of lower quality or performance standards, or to license such
technology at a greater cost. Both licensing inferior technology at a
reasonable cost and licensing necessary technology at a higher cost could

seriously harm the competitiveness of our products. Our Products Are Subject to Government Regulation. The export of our products and related technology may be subject at times
to regulation and restriction by the Department of Commerce. Because our
products are utilized in defense and intelligence gathering related
applications, in some cases the export of our products and related technology
may be subject to further regulation and restriction by the Department of
State. Sales to foreign countries have not been material to date, but export
controls could limit our ability to sell our products outside the United States
or could delay such sales in the future. We also may be required to spend
substantial time and resources in order to comply with the regulations and
restrictions. We could be subject to fines if we fail to properly comply with
these regulations. In addition, our business and operating results may also be adversely
affected by the imposition of certain tariffs, duties and other import
restrictions on components that we obtain from non-domestic suppliers or by the
imposition of export restrictions on products that we sell internationally. We
do not believe we have material exposure to environmental laws. Changes in
current or future laws or regulations, in the United States or elsewhere, could
materially and adversely affect our business and results of operations. 16




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RISK FACTORS RELATED TO THE SECURITIES MARKET Our Common Stock Is Subject to Price Volatility. The price of our common stock is volatile. Fluctuations in operating
results, such as revenues or operating results being below the expectations of
public market analysts and investors, may cause additional volatility in the
price of the common stock. In such event, the market price of our common stock
could decline significantly. A significant decline in the market price of the
common stock could result in litigation that could also result in increased
costs and a diversion of managements attention and resources from operations. There May Not Be a Liquid Market for our Common Stock. Our common stock currently is traded on the OTC Bulletin Board operated by
Nasdaq. This market generally has less liquidity than the Nasdaq SmallCap
Market and certain institutional investors are precluded from buying stock in
this market. There can be no assurance that our investors will be able to sell
our common stock at prices and times that are desirable. Additional Capital May Dilute Current Stockholders. In order to provide capital for the operation of our business we may enter
into additional financing arrangements. These arrangements may involve the
issuance of new common stock, preferred stock that is convertible into common
stock, debt securities that are convertible into common stock or warrants for
the purchase of common stock. Any of these items could result in a material
increase in the number of shares of common stock outstanding which would in
turn result in a dilution of the ownership interest of existing common
shareholders. In addition these new securities could contain provisions, such
as priorities on distributions and voting rights, which could affect the value
of our existing common stock. We May Propose a Reverse-Split of Our Common Stock. In order to reduce the number of shares outstanding, increase the trading
price of our common stock, qualify for listing on an exchange and possibly
attract additional groups of investors we may at some time in the future
propose a reverse-split of our common stock. Such a proposal would require the
approval of the majority of the outstanding shares of voting stock to be
implemented. There can be no assurance that a reverse split would have the
intended effect and therefore it could dilute the value of our common stock. 
 ITEM 2  PROPERTIES All of our facilities are leased and are located in Richardson, Texas. We
lease approximately 20,000 square feet under a lease agreement that expires in
January 2009. These facilities include production, engineering, sales,
marketing and administrative offices and we believe it to be suitable for our
current operations. 
 ITEM 3  LEGAL PROCEEDINGS We are involved in various legal proceedings and claims arising in the
ordinary course of business. Shareholder Action. A shareholder class action lawsuit was filed in the
U. S. District Court for the Northern District of Texas in November 1999 on
behalf of all persons and entities who purchased the Companys common stock
during the period between February 24, 1998 and November 17, 1998. The named
defendants include the Company and certain former and present officers and
directors of the Company. The complaint alleges that the defendants violated
Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder by making false and misleading statements concerning the
Companys reported financial results during the period, primarily relating to
revenue recognition, asset impairment and capitalization issues. The plaintiffs seek
monetary damages, interest, costs 17




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and expenses. In March 2001, our motion to
dismiss the case was denied. In December 2002, the Court denied the
plaintiffs motion for class certification. The plaintiffs appealed this
ruling to the 5th Circuit Court of Appeals and in March 2003 the appellate
court refused to hear the appeal. After additional discovery and certain
rulings by the Court, the complaint is now pending with 12 individual
plaintiffs. We have reached agreement in principle with each of the
plaintiffs to settle the matter. Pursuant to the settlement arrangements we
will make payments aggregating approximately $185,000. Completion of the
settlements is pending preparation of settlement and release documents and
approval of the settlement by the Court. Reliance Insurance Company (Reliance) provides the primary $2,000,000 of
insurance coverage for this matter. Reliance has been ordered liquidated by
the insurance commissioner of the State of Pennsylvania. We have previously
received $300,000 from the Texas Property and Casualty Guaranty Association
related to this claim. We believe that we have a claim against Reliance of
approximately $1,600,000 and have filed a proof of claim for this amount with
the Statutory Liquidator for Reliance. We do expect some recovery pursuant to
this claim, however, the amount of such recovery cannot be estimated at this
time and there is no assurance as to any recovery. In addition, the timing of
any recovery is uncertain and could be a matter of years. Accordingly, we have
not reflected any such recovery in our financial statements. Zurich American Insurance Company (Zurich) provides excess liability
coverage of up to $3,000,000, for amounts in excess of $2,000,000 related to
this matter. We do not believe that the total costs related to this matter
will invoke the coverage provided by Zurich. Nonetheless, Zurich has agreed to
advance to us the approximately $185,000 in settlement payments. Any such
amounts advanced will be evidenced by a note payable to Zurich, payable in two
years and will bear interest at 7% per annum, payable at maturity. The note
will be secured by warrants to purchase shares of our common stock. Contract Dispute. In March 2002, we entered into an agreement with
LaBarge, Inc. (LaBarge) for the development and manufacture of a conduction
cooled version of a certain model of our VQG4 product. In February 2003, we
terminated the contract because we believe LaBarge did not fully perform under
the contract and defaulted. Subsequent to February 2003, we engaged in a
series of discussions with LaBarge regarding the settlement of outstanding
issues, including claims of monies owed. We have been unable to resolve these
issues and in October 2003 litigation was commenced in the Circuit Court of the
County of St. Louis in the State of Missouri. In these proceedings LaBarge has
alleged that we improperly terminated the contract and seeks recovery of costs
and lost profits amounting to approximately $700,000. We have alleged that
LaBarge breached the contract and are seeking recovery of amounts previously
paid to LaBarge, costs incurred resulting from the breach and lost profits.
Such items aggregate in excess of $1,000,000. The ultimate resolution of this
matter cannot be determined at this time. 
 ITEM 4  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the quarter ended December 31, 2003, no matters were submitted to a
vote of our stockholders. 18




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PART II 
 ITEM 5  MARKETS FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our common stock is traded on the OTC Bulletin Board operated by Nasdaq
under the symbol TERA. The high and low bid prices for our common stock for each full quarter of
the last two fiscal years, as reported on the OTC Bulletin Board, are as
follows (these prices are inter-dealer prices, without mark-up, mark-down or
commission included and may not necessarily represent actual transactions): Quarter period ended
    
    High
    
    Low2003March 31
    
    
    0.240
    
    
    
    0.120June 30
    
    
    0.220
    
    
    
    0.140September 30
    
    
    0.490
    
    
    
    0.150December 31
    
    
    0.430
    
    
    
    0.2002002March 31
    
    
    0.240
    
    
    
    0.080June 30
    
    
    0.360
    
    
    
    0.090September 30
    
    
    0.240
    
    
    
    0.100December 31
    
    
    0.260
    
    
    
    0.100
 As of February 29, 2004, there were approximately 6,000 owners of record
of our common stock, including nominee holders such as banks and brokerage
firms who hold shares for the benefit of beneficial owners of our common stock. Dividend Policy No dividends were paid on any class of equity in 2003 or 2002. We do not
currently plan to pay any dividends on our common stock. Delaware law
restricts our ability to pay any dividends on our common stock. Sales of Unregistered Securities In October 2003 we issued 8,333,333 shares of our common stock for
$1,000,000 cash, a rate of $0.12 per share, related to the exercise of
conversion rights issued to a group of private investors that had provided
guaranties that secured a credit facility for DCS. The proceeds were used to
repay all amounts outstanding under the $1,000,000 credit facility and the
facility was cancelled. Also in October 2003 we issued 2,800,000 shares of our
common stock in cancellation of principal and interest totaling approximately
$700,000, a rate of approximately $0.25 per share, related to a note payable to
a private investor. Our sales of this common stock were exempt from registration pursuant to
Section 4(2) of the Securities Act of 1933, as amended (the Securities Act),
and pursuant to Rule 506 of Regulation D of the Securities Act. A Rule 506
exemption was available for these sales because the Company sold only to
accredited investors; the Company did not solicit or advertise the sales; a
restrictive legend was placed on each certificate issued describing the
restrictions against resale; and a Form D was filed with the Securities and
Exchange Commission and in each state where the individual investors reside. 19




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ITEM 6  SELECTED FINANCIAL DATA The following tables set forth certain historical consolidated financial
data for the Company. Years ended December 31,2003
    
    2002
    
    2001*
    
    2000*
    
    1999*($ in thousands, except per share data)Statement of Operations:Net revenues
    
    $
    6,207
    
    
    $
    5,036
    
    
    $
    6,822
    
    
    $
    11,748
    
    
    $
    12,103Operating loss
    
    $
    (5,521
    )
    
    $
    (7,235
    )
    
    $
    (16,724
    )
    
    $
    (29,062
    )
    
    $
    (23,241
    )Loss from continuing operations
    
    $
    (8,559
    )
    
    $
    (2,830
    )
    
    $
    (17,181
    )
    
    $
    (28,790
    )
    
    $
    (26,286
    )Loss from discontinued operations
    
    
    
    
    
    
    (1,520
    )
    
    
    (3,412
    )
    
    
    (782
    )
    
    
    (2,249
    )Loss on disposal of
discontinued operations
    
    
    
    
    
    
    
    
    
    
    (956
    )
    
    
    
    
    
    
    Extraordinary item  loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    

    
    
    
    (1,054
    )Net loss
    
    $
    (8,559
    )
    
    $
    (4,350
    )
    
    $
    (21,549
    )
    
    $
    (29,572
    )
    
    $
    (29,589
    )Loss allocable to common
stockholders
    
    $
    (8,559
    )
    
    $
    (4,350
    )
    
    $
    (21,549
    )
    
    $
    (30,538
    )
    
    $
    (34,517
    )Basic and diluted loss per share:Continuing operations
    
    $
    (0.07
    )
    
    $
    (0.03
    )
    
    $
    (0.20
    )
    
    $
    (0.36
    )
    
    $
    (0.67
    )Extraordinary item
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.02
    )Discontinued operations
    
    
    
    
    
    
    (0.02
    )
    
    
    (0.05
    )
    
    
    (0.01
    )
    
    
    (0.05
    )Net loss
    
    $
    (0.07
    )
    
    $
    (0.05
    )
    
    $
    (0.25
    )
    
    $
    (0.37
    )
    
    $
    (0.74
    )Weighted average shares (thousands)
    
    
    119,111
    
    
    
    93,581
    
    
    
    86,354
    
    
    
    83,229
    
    
    
    46,762Balance Sheet:Assets:Current assets
    
    $
    4,232
    
    
    $
    4,918
    
    
    $
    8,105
    
    
    $
    18,805
    
    
    $
    11,861Excess of cost over assets of
companies acquired
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,354
    
    
    
    4,115Other long-term assets
    
    
    1,116
    
    
    
    1,806
    
    
    
    2,091
    
    
    
    1,845
    
    
    
    8,366Total assets
    
    $
    5,348
    
    
    $
    6,724
    
    
    $
    10,196
    
    
    $
    24,004
    
    
    $
    24,342Liabilities & Stockholders Equity:Current liabilities including current
maturities of long-term debt
    
    $
    5,431
    
    
    
    7,358
    
    
    $
    11,807
    
    
    $
    4,593
    
    
    $
    8,674Long-term liabilities
    
    
    6,704
    
    
    
    2,000
    
    
    
    
    
    
    
    
    
    
    
    15,264Stockholders equity (deficit)
    
    
    (6,787
    )
    
    
    (2,634
    )
    
    
    (1,611
    )
    
    
    19,411
    
    
    
    404$
    5,348
    
    
    $
    6,724
    
    
    $
    10,196
    
    
    $
    24,004
    
    
    $
    24,342
 * Certain amounts have been reclassified to conform to current classifications. 20




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##### Table of Contents



ITEM 7  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS The following discussion should be read in conjunction with the
Consolidated Financial Statements and their related notes found on pages 31
through 53 of this Form 10-K. Except for historical facts, all statements
included in the following discussion about our financial position, business
strategy, and plans of management for future operations are forward-looking
statements. Forward-looking statements involve risks and uncertainties and
actual results could materially differ from those expressed in or implied by
the forward-looking statements. Results of Operations The following table shows the revenue and gross profit (loss) for our
products: Years Ended December 31,2003
    
    2002
    
    2001($ in Thousands)Net revenue:Defense electronic products
    
    $
    6,207
    
    
    $
    5,036
    
    
    $
    4,195Optical networking equipment
    
    
    
    
    
    
    
    
    
    
    2,368Other
    
    
    
    
    
    
    
    
    
    
    259$
    6,207
    
    
    $
    5,036
    
    
    $
    6,822Gross profit (loss):Defense electronic products
    
    $
    2,209
    
    
    $
    1,702
    
    
    $
    (424
    )Optical networking equipment
    
    
    
    
    
    
    
    
    
    
    Other
    
    
    
    
    
    
    
    
    
    
    (715
    )$
    2,209
    
    
    $
    1,702
    
    
    $
    (1,139
    )
 Net revenues Net revenue from the sale of defense electronics products increased 23%
between 2002 and 2003 and 20% between 2001 and 2002. The increased product
sales reflect our continued penetration of the market for these products and
customer acceptance of our products. The majority of the increase in net
revenues results from sales of our PowerPC-based product line. We have sold
these products into an increasing number of programs; however, many programs
have not yet reached their full production phase. In the full production
phase, orders tend to be larger and more predictable. In the fourth quarter of
2003 we received production orders for two programs for which we had previously
secured design wins. These programs contributed to the increase in net
revenues in 2003. We expect that these programs, and other programs that we
expect to move into the production phase in 2004, will contribute to increases
in our net revenues in 2004. We believe that general factors in our industry
have contributed to the historical increase in our net revenues and that these
factors will continue to do so. The demand for products such as ours has been
increasing as defense expenditures have increased and, more importantly we
believe, as the portion of those expenditures related to defense electronics
has increased. In November 2003 we entered into a Technology Licensing and Marketing
Agreement with VISTA. See Part I  Item 1  Business  Recent Developments.
Under this agreement we will receive up to $3,500,000 of licensing fees from
VISTA. As of December 31, 2003 we have recorded deferred revenue of $1,550,000
related to VISTA licensing fees that we had received, but we have not yet
recognized as revenue. We expect to receive substantially all of the balance
of the licensing fees and to recognize revenue related to these fees during
2004. We also believe that the agreement with VISTA will have a positive
effect on our net revenues through access to new products and access to
additional market channels. There is no assurance, however, as to the timing
or amount of this effect, if any. Net revenue from optical networking equipment relates almost exclusively
to the OmniLynx product line. In August 2001, we sold essentially all of the
assets related to the OmniLynx product line to ITI, of 21




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##### Table of Contents



which we continue to own a portion. Subsequent to August 2001, we have had
no revenues from optical networking equipment. Other revenues consist primarily of the voice and data switching products
used in air traffic control applications and video network products, which we
no longer sell. Gross profit (loss) Our gross profit from sales of defense electronics products increased
because of the higher sales levels in the respective periods. Generally, as
net revenues increase we expect to experience an increase in gross profit as a
percentage of net revenues, as certain costs of revenue are fixed in nature.
The gross profit percentage is also effected by the mix of products sold in a
particular period. In the fourth quarter of 2002 we recorded a charge of approximately
$270,000 to adjust the carrying value of component and finished goods
inventories. This adjustment resulted primarily from our on-going analysis of
component obsolescence. The gross loss related to defense electronics products
for 2001 includes approximately $750,000 of charges related to the adjustment
of the carrying value of component and finished goods inventories. These
charges resulted from an evaluation of current component costs and the
adjustment of certain finished goods to net realizable value. As of December 31, 2000, our assets related to the OmniLynx product line,
including inventories, were reduced to their estimated net realizable value.
Therefore, revenue from the sales of such OmniLynx products in 2001 produced no
gross profit or loss. The gross loss in 2001 represents manufacturing and
production overhead costs incurred in 2001. Engineering and development expenses Engineering and development (E&D) expense decreased to $2,574,000 in
2003 from $3,065,000 in 2002 and $5,096,000 in 2001. Total E&D expense by
product line was distributed as follows: Years ended December 31,2003
    
    2002
    
    2001($ in Thousands)Defense electronic products
    
    $
    2,574
    
    
    $
    2,803
    
    
    $
    2,286Optical networking products
    
    
    
    
    
    
    84
    
    
    
    1,336Other
    
    
    
    
    
    
    178
    
    
    
    1,474$
    2,574
    
    
    $
    3,065
    
    
    $
    5,096
 Included in E&D expenses for 2003 and 2002 is $193,000 and $800,000,
respectively, related to engineering design services provided by Flextronics
pursuant to the arrangement entered into with Flextronics concurrent with the
sale of our engineering design services business. The decline in E&D costs
related to our defense electronics products is due in large part to the reduced
services provided by
Flextronics in 2003. Activity in 2003 and 2002 primarily reflects on-going
enhancements to our VQG4 product line and development activity related to our
Eagle I product that was introduced in 2003. The increase in these costs
between 2001 and 2002 reflects the effect of the Flextronics arrangement, as
well as increased activity related to the Eagle I product. We do not expect a
material change in engineering and development costs in 2004 as compared to
2003. E&D costs related to optical networking products in 2001 relate to the
Aegean product line that we began developing in 2000. In the fourth quarter of
2001, we curtailed activity related to the Aegean product line because we were
unable to arrange outside funding for these activities. We ceased all
activities related to Aegean in the second quarter of 2002. Other E&D costs in 2001 included approximately $670,000 related to the
engineering organization involved with the OmniLynx product line, which was
eliminated during 2001. The balance of other E&D 22




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##### Table of Contents



costs in 2001 arose from
development activities on the Centauri product line. In the first quarter of
2002, we suspended all development activities related to the Centauri project. Selling and administrative expenses Selling and administrative expenses decreased $1,165,000, or 20%, between
2002 and 2003 and decreased $2,516,000, or 30%, between 2001 and 2002. The
decrease between 2002 and 2003 results from lower general and administrative
costs such as insurance, professional fees and personnel costs. This decrease
is offset by increased selling costs arising from the increase in net revenues.
We generally expect 2004 administrative costs to approximate those in 2003 and
expect selling costs to increase with the increase in net revenues. The
decrease between 2001 and 2002 was in large part because of the curtailment and
sale of the operations related to the OmniLynx product line. The decrease
between 2001 and 2002 was offset by increased general and administrative
expenses related to our defense electronics business. Amounts related to OmniLynx assets and ITI Subsequent to the sale to ITI of substantially all of the assets related
to the OmniLynx product line, ITI has conducted all operations related to the
OmniLynx product. We initially had a 33% equity interest in ITI, which
decreased to 22% in February 2003. We have minority representation on ITIs
board of directors, no funding obligations and no involvement in day-to-day
operations. We account for our investment in ITI using the equity method of
accounting. Earnings of $34,000 in 2001 and loss of $582,000 in 2002 represent
our proportionate share of the net earnings or loss of ITI for each of those
periods. In August 2001 we sold substantially all of the OmniLynx assets to ITI.
We received a cash payment of $1,000,000 and are entitled to receive additional
amounts from ITI based upon the utilization of inventory acquired from us and
based on the financial position of ITI at specific points in time. The total
additional amount to be received could not be determined at that time. The
amounts due from ITI were recorded at the carrying value of the assets disposed
of, less amounts received from ITI. Accordingly, no gain or loss was been
recorded as a result of that transaction. In 2001, we recognized non-recurring costs in connection with the sale of
the OmniLynx assets that amounted to $2,101,000. These costs related to
maintaining the assets until the sale and the settlement of certain contractual
obligations related to those assets such as warranty obligations, employee
retention agreements and lease obligations. In October 2003 we reached an agreement in principal with a third party to
sell our interest in ITI and to settle all amounts due from or to ITI for a
cash payment totaling $250,000. Accordingly, we had adjusted the carrying
value of our investment in ITI to $250,000. This resulted in a write-off of
the receivable from ITI of $669,000 and a charge of $452,000 to adjust the
carrying value of our investment in ITI. Litigation settlement In April 2002, we settled litigation that we had brought against Cadence.
See Item 3  Legal Proceedings. Pursuant to this settlement we received
$6,300,000, net of fees paid to our attorneys related to this matter. Litigation costs Litigation costs represent legal fees and expenses related to a
stockholder suit. We have reached an agreement in principal to settle this
litigation and have recorded a provision for the settlement and estimated costs
to affect it. See Item 3  Legal Proceedings. The allegations in the suit
relate to operations that have
been sold or otherwise discontinued; therefore, these costs are reflected as
non-operating expenses. Amounts incurred by the Company in excess of $200,000
are reimbursable under an insurance policy. However, the insurance carrier
that provides the first $2,000,000 of such coverage is in liquidation and has 23




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##### Table of Contents



not paid any amounts to us. We have received $300,000 from a guarantee fund
maintained by the State of Texas. The costs for 2002 have been reduced by
$300,000. We have filed a claim for approximately $1,600,000 with the
liquidator for this carrier and we expect to recover some amounts. The amount
and timing of any such recovery is uncertain. Therefore, no estimate of any
such recovery has been recorded. Interest expense Interest expense, including non-cash financing charges, consists of the
following: Years ended December 31,2003
    
    2002
    
    2001($ in Thousands)Interest on debt instruments
    
    $
    384
    
    
    $
    291
    
    
    $
    151Non-cash financing costs
    
    
    1,448
    
    
    
    125
    
    
    
    82Other interest
    
    
    15
    
    
    
    92
    
    
    
    29$
    1,847
    
    
    $
    508
    
    
    $
    262
 Non-cash financing costs consists of amortization of the value of warrants
to purchase common stock issued in connection with various financings and, in
2003, approximately $121,000 related to a beneficial conversion feature. The
value of the warrants has been determined by using the Black-Scholes pricing
model and amortized over the life of the underlying debt. The beneficial
conversion feature arose from the conversion of a note payable into common
stock during 2003. Discontinued operations The loss from discontinued operations of $1,520,000 in 2002 results from a
charge recorded in the third quarter of 2002 relating to the settlement of
certain indemnification obligations. These obligations arose from the sale of
certain operations to Savage Sports. See Item 3  Legal Proceedings. Effective December 31, 2001 we commenced a plan to dispose of our
engineering design services business and on January 11, 2002 sold substantially
all of the assets related to this business for total consideration of
$2,800,000. Accordingly, this business segment has been accounted for as a
discontinued operation. The loss on disposal of discontinued operations in 2001 is computed based
on the consideration received less the net book value of the assets disposed
of, including goodwill, and the operating loss of the business from December
31, 2001 to the date of disposal, which amount includes severance costs related
to certain employees, and an estimate of the costs related to a real estate
lease utilized by the discontinued operation. The amount of the loss is as
follows: ($ in Thousands)Proceeds
    
    $
    2,800Net book value of assets sold
    
    
    (517
    )Goodwill
    
    
    (2,682
    )Operating loss through date of sale
    
    
    (308
    )Estimated cost of real estate lease
    
    
    (249
    )Loss on disposal of discontinued operation
    
    $
    956
 The results of operations related to our engineering design services
business are reflected as loss from discontinued operations in 2001. 24




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##### Table of Contents



Outlook for 2004 Net revenue from the sale of our defense electronic products has increased
in each of the last three years and we expect it to further increase in 2004.
Net revenue from these sales amounted to $6,207,000 in 2003, including
$2,170,000 in the fourth quarter of 2003. Not included in net revenue in 2003
is $1,550,000 of deferred revenue related to license fees we received from
VISTA in 2003. We expect increases in net revenue to occur as a result of
continued sales of our products into programs for which we have previously
secured design wins and due to new programs. However, there can be no
assurance that this increase will occur or that there will not be further
delays in these and other programs. We expect net revenues to increase in 2004
due to the recognition of license fee revenue related to our agreement with
VISTA. We also expect the VISTA agreement to have a positive effect on our
product sales, but the timing and magnitude of this effect is uncertain. Our ability to generate a profit from operations and to generate positive
cash flow from operations largely depends on the continued growth in revenue
from sales of defense electronics products. Our ability to achieve higher
levels of net revenue depends upon a number of factors, including customer
acceptance of our products, including new and enhanced products, our ability to
meet customer demands as to product availability, price and performance,
availability of funding for programs in which our products will be deployed,
the performance of other companies who provide products or services to these
programs and our access to adequate working capital, as well as other factors
that may not be within our control (See Item 1  Business  Risk Factors). In order to execute our business plan we may need access to capital. See
"- Liquidity and Capital Resources  Financing Activities for a discussion of
these requirements and how we expect to meet them. Liquidity and Capital Resources As of December 31, 2003, we had cash and temporary investments of $165,000
and negative working capital of $1,199,000, which included $1,550,000 of
deferred revenue. Funded debt at December 31, 2003 amounted to $7,430,000 and
other long-term liabilities amounted to $795,000. For the year ended December
31, 2003, cash flow used in operations amounted to $4,776,000. Operating activities Net cash applied in operations reflects the net loss of $8,559,000,
non-cash charges amounting to $3,408,000 and a decrease in net operating assets
of $375,000. Significant items contributing to these amounts are as follows:  
    
    Inventories decreased $758,000 because we utilized our
inventories on hand to fulfill our increased net revenues in 2004.
We expect to utilize additional inventories in 2004.  
    
    Accounts receivable increased $1,362,000 because of increased
net revenues, particularly related to shipments late in 2003.  
    
    Accounts payable and accrued liabilities decreased $571,000
as we generally made payments to vendors more quickly than in prior
periods.  
    
    Deferred revenue increased $1,550,000. This relates to
license fees we received from VISTA in 2003 that we did not
recognize as revenue. We expect to recognize this amount as revenue
in 2004.  
    
    Non-cash charges include the following:  
    
    Amortization of deferred financing costs of $1,448,000.
These non-cash financing costs relate to warrants issued in
connection with financing transactions and beneficial conversion
features related to certain of the transaction. We expect these
charges to decrease in 2004.
    
    Depreciation and amortization of $247,000, which we do
not expect to be materially different in 2004.
    
    Utilization of prepaid services of $193,000. This
relates to our agreement with Flextronics that was completed in
2003. 25




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##### Table of Contents




    
    Amounts related to ITI of $1,151,000. We do not expect
any such charges in 2004. Investing activities Cash flows from investing activities in 2003 includes $457,000 from the
redemption of temporary cash investments, less capital expenditures and
capitalized software development costs of $137,000. Financing activities In January and March 2003, we completed private placement transactions in
which we issued a total of 4,166,667 shares of common stock and warrants for
the purchase of an additional 4,333,333 shares of common stock for aggregate
net proceeds of $494,000. The warrants have an exercise price of $0.15 per
share and are exercisable at any time through March 31, 2007. In March 2003, the Company and DCS entered into a revolving line of credit
with a bank in order to provide working capital to DCS. Under the facility,
DCS could borrow up to $1,000,000. Outstanding amounts were due March 26,
2004; however, DCS could extend the maturity date six months, provided certain
conditions are maintained. Interest was payable monthly at the greater of
prime plus 1% and 5.25%. This working capital facility was secured by the
accounts receivable and inventories of DCS, the guarantee of the Company and by
limited guarantees provided by certain private investors. As consideration for
providing the guarantees that secured the Note, the Company entered into a
Reimbursement Agreement with the guarantors. The Reimbursement Agreement
provided that the Company would reimburse the investors for any amounts that
may be required to reimburse the bank pursuant to the guarantees. Pursuant to
the Reimbursement Agreement and related agreements, the investors had the right
to purchase up to 8,333,333 shares of the Companys common stock for $1,000,000
in cash, and the proceeds would be used to repay amounts outstanding under the
Note and provide for the release of the guarantees. In addition, the investors
received warrants to purchase an aggregate of 9,582,334 shares of the Companys
common stock at a price of $0.15 per share. The warrants may be exercised at
any time through March 31, 2007. In October 2003, the investors exercised
their purchase rights and purchased 8,333,333 shares of common stock for
$1,000,000 cash. The proceeds were used to repay all amounts outstanding under
the facility, $1,000,000 at the time, and the facility was cancelled. In July and August 2003, we issued $3,260,000 principal amount of
convertible subordinated notes. We received net proceeds of approximately
$3,059,000, after paying sales commissions and legal costs related to the
offering. The notes are due June 30, 2005 and bear interest at 12%, payable
annually. The holders of the notes may convert outstanding principal and
accrued interest on the notes into our common stock at the rate of $0.16 per
share. We may redeem the notes at any time beginning in November 2003. To
redeem the notes before June 1, 2004, we must pay the holders 110% of the
outstanding principal amount and all accrued interest. If we redeem the notes
after June 1, 2004, we must pay 105% of the outstanding principal amount and
all accrued interest. We also issued warrants to purchase an aggregate of
1,881,250 shares of our common stock to the purchasers of the notes. The
warrants have a four-year term and an exercise price of $0.16 per share. Also in July 2003 we restructured some of our outstanding debt. We
amended our $1.5 million and $2.7 million credit agreements with Bank One to
combine them into a single $4.2 million credit agreement. The maturity of the
amended agreement was extended to June 27, 2004, with no mandatory reductions
prior to that date. The amended credit agreement is secured by a letter of
credit provided by a private investor. At September 30, 2003 principal and
accrued interest outstanding pursuant to a note payable to a private investor
amounted to approximately $700,000. In October 2003, this investor agreed to
cancel the note in exchange for 2,800,000 shares of the Companys common stock
and the extension of the maturity date of common stock warrants previously
issued to the investor. Warrants are for the purchase of an aggregate of
2,790,000 shares of common stock at a price of $0.12 per share and had been
issued to the investor in
connection with previous financing transactions. The expiration dates of the
warrants, which ranged from December 31, 2003 to October 31, 2004, have been
extended to October 31, 2005. 26




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##### Table of Contents



In March 2004, we further restructured the credit agreement with Bank One.
Under the amended agreement all amounts outstanding are due April 30, 2005.
In addition, the amount available under the facility will decrease by $300,000
as of June 30, 2004 and December 31, 2004. The letter of credit that secures
this facility has been amended to correspond with the amended facility. As
consideration for extending the letter of credit, we have issued options to
purchase a total of 6,500,000 shares of our common stock to the private
investor who provides the letter of credit. Warrants for the purchase of
3,250,000 shares have an exercise price of $0.29 per share and warrants for the
purchase of 3,250,000 shares have an exercise price of $0.55 per share. The
warrants may be exercised at any time until their expiration on April 30, 2006. As discussed above we are obligated under various contracts and commercial
commitments. The following table summarizes these obligations: Period in which payments due (in thousands)Nature of Obligation
    
    2004
    
    2005
    
    2006
    
    2007
    
    ThereafterNotes payable
    
    $
    700
    
    
    $
    6,730
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating leases
    
    
    284
    
    
    
    224
    
    
    
    217
    
    
    
    222
    
    
    
    246Non-cancelable purchasecommitments
    
    
    669
    
    
    
    206
    
    
    
    
    
    
    
    
    
    
    
    Settlement payments
    
    
    700
    
    
    
    600
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    2,353
    
    
    $
    7,760
    
    
    $
    217
    
    
    $
    222
    
    
    $
    246
 We expect to generate positive cash flow from operations in 2004 and
expect that such cash flow will be adequate to meet our obligations during
2004. Our estimate of capital needs is subject to a number of risks and
uncertainties that could result in additional capital needs that have not been
anticipated. An important aspect of our estimated capital requirements is our
ability to begin to generate positive cash flow from operations. As discussed
above, this in turn is dependent upon our ability to increase revenues from our
defense electronics business, to generate adequate gross profit from those
sales and to control other costs and expenses. Our capital needs could
increase materially if any of our contingent liabilities are resolved adversely
to the Company. In addition, we could require additional working capital if
the defense electronics business increases more rapidly than we currently
anticipate. Approximately $7,430,000 of debt is due in 2005. Of this, $3,130,000
relates to subordinated convertible notes that are convertible into common
stock at the rate of $0.16 per share. From January 1, 2004 to February 29,
2004 our common stock closed at prices ranging from $0.24 to $0.36 per share.
We expect this debt will be converted into common stock prior to its maturity
in June 2005. As of February 29, 2004 $130,000 of the original issue of these
notes had been converted into common stock. The balance of the debt due in
2004 relates to our guaranteed bank facility. We expect to able to refinance
or otherwise extend this facility prior to its maturity in June 2005. Should we need additional capital during 2004 or thereafter we expect that
we will be able to secure it, as we have in the past. Potential sources of
additional capital include the sale of additional debt or equity securities and
other debt, such as bank debt. We could decide to raise additional capital
during 2004 prior to a specific need for it arising. We might due this in
order to provide the Company additional operating flexibility or to take
advantage of opportunities to raise capital that might not be available at
another time. A sale of additional securities could result in dilution to
existing common shareholders. There is no assurance that additional capital
will be available under terms which are acceptable. Contingent liabilities As discussed in Item 3  Legal Proceedings, we are exposed to certain
contingent liabilities which, if resolved adversely to us, could adversely
affect our liquidity, our results of operations, and/or our financial position. 27




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##### Table of Contents



Critical Accounting Policies We have identified the policies below as critical to our business
operations and the understanding of our results operations. The impact and any
associated risks related to these policies on our business operations is
discussed below. For a more detailed discussion on the application of these
and other accounting policies, see the Notes to the Consolidated Financial
Statements included in this Annual Report on Form 10-K. The preparation of
financial statements in accordance with generally accepted accounting
principles requires management to make estimates and assumptions that affect
the reported amount of assets, liabilities, revenue and expenses and the
disclosure of contingent assets and liabilities. There can be no assurance
that the actual results will not differ from those estimates. Estimates Management has made estimates regarding the following matter which could
have a material effect on our consolidated financial statements:  
    
    Valuation of warrants issued in debt transactions. Inventories Our inventories consist primarily of electronic components that are
subject to obsolescence and variations in market prices. We have adjusted the
amount of excess and obsolete inventory based on current and expected sales
trends, the number of parts on hand, the current market value for those parts
and the viability and potential technical obsolescence of the components. Revenue recognition We generally recognize revenue when our products are shipped to the
customer. This is normally the point when all of the following factors have
been achieved:  
    
    Persuasive evidence of a sales arrangement exists, such as a contract or binding purchase order,  
    
    The product has been delivered to the customer,  
    
    The price is fixed or determinable, and  
    
    Collection of the resulting receivable is reasonably assured. In some cases the product is shipped to a customer for evaluation or
testing. In such cases, revenue is not recognized until the customer has
evidenced intent to purchase the product by issuing a non-cancelable purchase
order to us for the product. License fees are generally recognized at the point we have met essentially
all our obligations under the related license agreement and collection of the
fees is reasonably assured. In the case of arrangements under which we are
obligated to deliver more than one item, we recognize the license fees in
accordance with EITF 00-21, Revenue Arrangements With Multiple Deliverables.
License fees received prior to the point at which the related revenue is
recognized are recorded as deferred revenue. 
 ITEM 7A  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We have outstanding debt amounting to $4,200,000 that bears interest at a
variable interest rate. This interest rate is based on a widely used reference
interest rate known as LIBOR. An increase of 50 basis points in LIBOR would
result in an increase in our annual interest expense of $21,000. 28




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ITEM 8  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Certified Public Accountants
    
    
    30Consolidated Balance Sheets
    
    
    31Consolidated Statements of Operations
    
    
    32Consolidated Statements of Stockholders Equity (Deficit)
    
    
    33Consolidated Statements of Cash Flows
    
    
    34Notes to Consolidated Financial Statements
    
    
    35
 29




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REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Board of Directors and Stockholders
TeraForce Technology Corporation We have audited the accompanying consolidated balance sheets of TeraForce
Technology Corporation and subsidiaries as of December 31, 2003 and 2002, and
the related consolidated statements of operations, stockholders equity
(deficit), and cash flows for each of the three years in the period ended
December 31, 2003. These financial statements are the responsibility of the
Companys management. Our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of TeraForce
Technology Corporation and subsidiaries as of December 31, 2003 and 2002, and
the consolidated results of their operations and their consolidated cash flows
for each of the three years in the period ended December 31, 2003 in conformity
with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 3 to the
financial statements, the Company has incurred significant operating losses in
2003, 2002 and 2001 and is experiencing difficulty in generating operating cash flows, which raises substantial doubt about the Companys ability to continue as a
going concern. Managements plans with respect to these matters are also
discussed in Note 3. The financial statements do not include any adjustments
that might result from the outcome of this uncertainty. /s/ Grant Thornton LLP Dallas, Texas
March 12, 2004 30




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 2003 and 2002
(Thousands of dollars, except share data) 2003
    
    2002AssetsCurrent assets:Cash and cash equivalents
    
    $
    165
    
    
    $
    55Temporary cash investments
    
    
    
    
    
    
    457Accounts receivable, net of allowance of $30 in 2003
    
    
    1,935
    
    
    
    573Receivables from affiliate
    
    
    
    
    
    
    699Inventories
    
    
    1,595
    
    
    
    2,354Prepaid expenses and other current assets
    
    
    537
    
    
    
    780Total current assets
    
    
    4,232
    
    
    
    4,918Property and equipment, net
    
    
    378
    
    
    
    573Investment in affiliate
    
    
    250
    
    
    
    702Other assets
    
    
    488
    
    
    
    531$
    5,348
    
    
    $
    6,724Liabilities and Stockholders DeficitCurrent liabilities:Current portion of notes payable
    
    $
    700
    
    
    $
    4,047Accounts payable
    
    
    1,495
    
    
    
    1,919Deferred revenue
    
    
    1,550
    
    
    
    Accrued liabilities
    
    
    1,686
    
    
    
    1,392Total current liabilities
    
    
    5,431
    
    
    
    7,358Long-term notes payable
    
    
    5,909
    
    
    
    900Other long-term liabilities
    
    
    795
    
    
    
    1,100Commitments and contingencies (Notes 10 and 15)Stockholders deficit:Common Stock, $.01 par value. Authorized 200,000,000 shares,
130,837,186 and 114,255,518 shares issued in 2003 and
2002, respectively
    
    
    1,308
    
    
    
    1,143Additional paid-in capital
    
    
    189,194
    
    
    
    184,953Accumulated deficit
    
    
    (195,702
    )
    
    
    (187,143
    )(5,200
    )
    
    
    (1,047
    )Less 400,474 shares of common stock in treasury -at cost
    
    
    (1,587
    )
    
    
    (1,587
    )Total stockholders deficit
    
    
    (6,787
    )
    
    
    (2,634
    )$
    5,348
    
    
    $
    6,724
 See accompanying notes to consolidated financial statements. 31




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
(Thousands of dollars, except share data) Years ended December 31,2003
    
    2002
    
    2001Net revenue
    
    $
    6,207
    
    
    $
    5,036
    
    
    $
    6,822Cost of revenue
    
    
    3,998
    
    
    
    3,334
    
    
    
    7,961Gross profit (loss)
    
    
    2,209
    
    
    
    1,702
    
    
    
    (1,139
    )Expenses:Engineering and development
    
    
    2,574
    
    
    
    3,065
    
    
    
    5,096Selling and administrative
    
    
    4,707
    
    
    
    5,872
    
    
    
    8,388Write-off of receivable from unconsolidated
affiliate
    
    
    699
    
    
    
    
    
    
    
    Costs related to sale of assets
    
    
    
    
    
    
    
    
    
    
    2,1017,980
    
    
    
    8,937
    
    
    
    15,585Operating loss
    
    
    (5,771
    )
    
    
    (7,235
    )
    
    
    (16,724
    )Other income (expense):Litigation settlement
    
    
    
    
    
    
    6,300
    
    
    
    Litigation costs
    
    
    (442
    )
    
    
    (872
    )
    
    
    (282
    )Share of income (loss) and adjustment to
carrying value of unconsolidated
affiliate
    
    
    (452
    )
    
    
    (582
    )
    
    
    34Interest expense
    
    
    (1,847
    )
    
    
    (508
    )
    
    
    (262
    )Interest income and other
    
    
    (47
    )
    
    
    67
    
    
    
    53(2,788
    )
    
    
    4,405
    
    
    
    (457
    )Loss from continuing operations
    
    
    (8,559
    )
    
    
    (2,830
    )
    
    
    (17,181
    )Loss from discontinued operations
    
    
    
    
    
    
    (1,520
    )
    
    
    (3,412
    )Loss on disposal of discontinued operations
    
    
    
    
    
    
    
    
    
    
    (956
    )Net loss
    
    $
    (8,559
    )
    
    $
    (4,350
    )
    
    $
    (21,549
    )Basic and diluted loss per share:Continuing operations
    
    $
    (0.07
    )
    
    $
    (0.03
    )
    
    $
    (0.20
    )Discontinued operations
    
    
    
    
    
    
    (0.02
    )
    
    
    (0.05
    )Net loss per share
    
    $
    (0.07
    )
    
    $
    (0.05
    )
    
    $
    (0.25
    )Weighted average number of common
shares outstanding (thousands)
    
    
    119,111
    
    
    
    93,581
    
    
    
    86,354
 See accompanying notes to consolidated financial statements. 32




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
Consolidated Statements of Stockholders Equity (Deficit)
Years ended December 31, 2003, 2002 and 2001
(Thousands of dollars, except share data) TotalCommon Stock
    
    Additionalpaid-in
    
    Accumu-lated
    
    Treasury Stock
    
    stock-holdersShares
    
    Par
    
    capital
    
    deficit
    
    Shares
    
    Cost
    
    equityBalances at December 31, 2000
    
    
    86,098,850
    
    
    $
    861
    
    
    $
    181,381
    
    
    $
    (161,244
    )
    
    
    400,474
    
    
    $
    (1,587
    )
    
    $
    19,411Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (21,549
    )
    
    
    
    
    
    
    
    
    
    
    (21,549
    )Stock issued in settlement of
contractual obligations
    
    
    990,000
    
    
    
    10
    
    
    
    377
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    387Warrants issued with notes
    
    
    
    
    
    
    
    
    
    
    140
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    140Balances at December 31, 2001
    
    
    87,088,850
    
    
    
    871
    
    
    
    181,898
    
    
    
    (182,793
    )
    
    
    400,474
    
    
    $
    (1,587
    )
    
    $
    (1,611
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,350
    )
    
    
    
    
    
    
    
    
    
    
    (4,350
    )Warrants issued with notes
    
    
    
    
    
    
    
    
    
    
    307
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    307Stock issued in exchange of warrants
    
    
    2,000,000
    
    
    
    20
    
    
    
    (20
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Private placements of common stock
    
    
    25,166,668
    
    
    
    252
    
    
    
    2,768
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,020Balances at December 31, 2002
    
    
    114,255,518
    
    
    
    1,143
    
    
    
    184,953
    
    
    
    (187,143
    )
    
    
    400,474
    
    
    $
    (1,587
    )
    
    $
    (2,634
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (8,559
    )
    
    
    
    
    
    
    
    
    
    
    (8,559
    )Warrants issued with debt financing
    
    
    
    
    
    
    
    
    
    
    2,019
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,019Exercise of employee stock options
    
    
    134,402
    
    
    
    1
    
    
    
    21
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    22Exercise of warrants
    
    
    300,000
    
    
    
    3
    
    
    
    33
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    36Conversion of subordinated debt
    
    
    847,266
    
    
    
    8
    
    
    
    128
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    136Stock issued in exchange for debt
    
    
    2,800,000
    
    
    
    28
    
    
    
    671
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    699Exercise of purchase rights
    
    
    8,333,333
    
    
    
    83
    
    
    
    917
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,000Private placements of common stock
    
    
    4,166,667
    
    
    
    42
    
    
    
    452
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    494Balances at December 31, 2003
    
    
    130,837,186
    
    
    $
    1,308
    
    
    $
    189,194
    
    
    $
    (195,702
    )
    
    
    400,474
    
    
    $
    (1,587
    )
    
    $
    (6,787
    )
 See accompanying notes to consolidated financial statements. 33




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years ended December 31, 2003, 2002 and 2001
(Thousands of dollars) Years ended December 31,2003
    
    2002
    
    2001Cash flows from operating activities:Net loss
    
    $
    (8,559
    )
    
    $
    (4,350
    )
    
    $
    (21,549
    )Adjustments to reconcile net loss to
net cash used in operating activities:Accrued settlement obligation
    
    
    
    
    
    
    1,445
    
    
    
    Utilization of prepaid services
    
    
    193
    
    
    
    807
    
    
    
    Depreciation and amortization
    
    
    247
    
    
    
    256
    
    
    
    1,417Amortization of deferred financing costs
    
    
    1,448
    
    
    
    72
    
    
    
    87Amounts related to unconsolidated affiliate
    
    
    1,151
    
    
    
    582
    
    
    
    (34
    )Other
    
    
    369
    
    
    
    (377
    )
    
    
    59Change in operating assets and liabilities:Accounts receivable
    
    
    (1,362
    )
    
    
    415
    
    
    
    4,569Inventories
    
    
    758
    
    
    
    908
    
    
    
    (1,139
    )Assets held for sale
    
    
    
    
    
    
    
    
    
    
    2,643Deferred revenue
    
    
    1,550
    
    
    
    
    
    
    
    Accounts payable and accrued liabilities
    
    
    (571
    )
    
    
    (730
    )
    
    
    158Net cash used in operating activities
    
    
    (4,776
    )
    
    
    (972
    )
    
    
    (13,789
    )Cash flows from investing activities:Capital expenditures
    
    
    (32
    )
    
    
    (179
    )
    
    
    (325
    )Investment in temporary cash investments
    
    
    457
    
    
    
    (404
    )
    
    
    Net proceeds from disposal of discontinued operations
    
    
    
    
    
    
    1,244
    
    
    
    Proceeds from sale of assets
    
    
    
    
    
    
    
    
    
    
    2,250Investment in affiliate
    
    
    
    
    
    
    
    
    
    
    (1,250
    )Software development costs
    
    
    (137
    )
    
    
    
    
    
    
    Investment and other
    
    
    
    
    
    
    
    
    
    
    73Net cash provided by
investing activities
    
    
    288
    
    
    
    661
    
    
    
    748Cash flows from financing activities:Proceeds from issuance of notes payable
    
    
    4,046
    
    
    
    700
    
    
    
    7,455Proceeds from issuance of common stock
    
    
    1,494
    
    
    
    3,020
    
    
    
    Principal payments on notes payable
    
    
    (1,000
    )
    
    
    (3,355
    )
    
    
    Proceeds from exercise of common stock warrants
    
    
    36
    
    
    
    
    
    
    
    Proceeds from exercise of employee stock options
    
    
    22
    
    
    
    
    
    
    
    Net cash provided by financing
activities
    
    
    4,598
    
    
    
    365
    
    
    
    7,455Net increase (decrease) in cash and cash equivalents
    
    
    110
    
    
    
    54
    
    
    
    (5,586
    )Cash and cash equivalents, beginning of year
    
    
    55
    
    
    
    1
    
    
    
    5,587Cash and cash equivalents, end of year
    
    $
    165
    
    
    $
    55
    
    
    $
    1
 See accompanying notes to consolidated financial statements. 34




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements  (1)
    
    Description of BusinessThe Companys defense electronics business designs, develops, produces and
sells high-capacity embedded computing products which are used primarily in
defense related applications. Beginning in 2001 this business is conducted
through the Companys wholly-owned subsidiary, DNA Computing Solutions,
Inc. (DCS).Prior to 2002 the Company operated, through various subsidiaries, in three
business segments, optical networking equipment, engineering design
services, and defense electronics products (formerly referred to as digital
signal processor or DSP). In addition, from 2001 through the first quarter
of 2002 the Company conducted limited development activities regarding
high-density computing systems.Prior to 2001 the Companys optical networking equipment business was
conducted primarily through its wholly-owned subsidiary, Intelect Network
Technologies Company (INT). In August 2001 substantially all of the
assets of this company, which related to the OmniLynx product line, were
sold to a new entity, Intelect Technologies, Inc. (ITI). ITI is owned
78% by an unrelated third party and 22% by the Company at December 31,
2003. The Company also conducted limited development activities related to
a new generation of optical networking equipment through a wholly-owned
subsidiary, Aegean Networks, Incorporated from 2001 through the second
quarter of 2002 (see Note 6).The Companys engineering design services business, which was conducted
through its wholly-owned subsidiary, DNA Enterprises, Inc., historically
provided high-value product design and development services, primarily to
telecommunications and networking companies. As of December 31, 2001 the
Company commenced a plan to dispose of this business segment. Accordingly,
the operations related to the design services business have been accounted
for as discontinued operations. These operations were sold in January
2002.(2)
    
    Significant Accounting Policies and PracticesEstimatesThe accompanying consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United
States of America. These principles require 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.Principles of ConsolidationThe consolidated financial statements include the financial statements of the
Company and its wholly-owned subsidiaries. All significant intercompany
balances and transactions have been eliminated in consolidation. The Companys
investment in ITI is accounted for using the equity method of accounting. 35




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  Fair Value of Financial InstrumentsThe fair value of a financial instrument is the amount at which the
instrument could be exchanged in a current transaction between willing
parties, other than in a forced sale or liquidation. The carrying values
of cash, temporary cash investments, accounts receivable, notes
payable and accounts payable are reasonable estimates of fair value due to
their current maturities.Revenue and Expense RecognitionRevenue from product sales is generally recognized upon shipment of
products. This is normally the point at which (a) there is persuasive
evidence of a sales arrangement, such as a contract or binding purchase
order; (b) the product has been delivered to the customer; (c) the price is
fixed or determinable; and (d) collection of the resulting receivable is
reasonably assured. In some cases product is shipped to a customer for
evaluation or testing. In such cases, revenue is not recognized until the
customer has evidenced intent to purchase the product by issuing a
non-cancelable purchase order. Estimated sales returns are recorded in the
same accounting period as the related revenues.Revenue from licensing arrangements is recognized at such time that the
Company has delivered all required items and that collection of amounts due
the Company are reasonably assured, unless earlier recognition of a portion
of such amounts is justifiable pursuant to EITF 00-21. At December 31,
2003 recognition of licensing fee revenue amounting to $1,550,000 had been
deferred.InventoriesInventories consist of raw materials, work in progress and finished goods,
and are stated at the lower of cost (determined on a first-in, first-out
basis) or market.Property and EquipmentProperty and equipment are generally stated at cost. Property and
equipment that in the opinion of management will no longer be utilized in
the Companys operations is valued at the lower of cost and fair value less
estimated costs of disposal.Depreciation of equipment is calculated on a straight-line method over the
estimated useful lives of the assets. Equipment held under capital leases
and leasehold improvements are amortized on a straight-line basis over the
shorter of the lease term or estimated useful life of the assets and
included in depreciation expense. The estimated useful lives are as
follows: YearsMachinery and equipment
    
    5 to 7Computer equipment
    
    3 to 5Software
    
    
    3Furniture and fixtures
    
    5 to 7Leasehold improvements
    
    
    5
 36




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  Receivable From and Investment in AffiliateIn connection with the sale of the OmniLynx product line, the Company
recorded a receivable from ITI in an amount equal to the carrying value of
the assets sold. This amount was equal to the estimated net realizable
value of those assets. Amounts are payable by ITI to the Company based on
the utilization of those assets by ITI and on the financial condition of
ITI at certain points in time (see Note 6). The Company assesses the net
realizable value of the receivable from ITI based on the historical and
projected operating results of ITI and on periodic analysis provided to the
Company by ITI.The Companys investment in ITI is accounted for using the equity method of
accounting. Accordingly, the Company recognizes its proportionate share of
ITIs net earnings or loss. The Company further assesses the
recoverability of its investment base on various factors, including the
operating results and financial condition of ITI.Deferred Financing CostsA portion of the proceeds from the issuance of convertible debt securities
with beneficial conversion features and/or detachable stock purchase
warrants is recognized as additional paid-in capital and as a discount to
its related debt instrument. The discount related to beneficial conversion
features, deferred financing costs in connection with the issuance of debt,
and the discount related to detachable stock purchase warrants are
amortized on the straight-line method, which has produced results similar
to the effective interest method.Engineering and Development and Software Development CostsEngineering and development costs are expensed as incurred. Capitalization
of software development costs commences upon the establishment of
technological feasibility and ceases when the product is generally
available for sale. Both the establishment of technological feasibility
and the ongoing assessment of recoverability of capitalized development
costs involve judgments by management with respect to certain external
factors, including, but not limited to, anticipated future revenues,
estimated economic life and possible developments in software and hardware
technologies. Amortization is based on the greater of estimated product
revenues or two years.Basic Loss Per Common ShareThe Company uses the weighted average number of shares outstanding to
compute basic loss per share and diluted loss per share. Diluted loss per
share is computed using the weighted average number of common shares and
dilutive potential common shares outstanding. In 2003, 2002 and 2001 all
potential common shares were anti-dilutive. 37




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  Income TaxesThe Company accounts for income taxes under the liability method whereby
deferred tax assets and liabilities are determined based on differences
between the financial reporting and income tax bases of assets and
liabilities and are measured using the enacted tax rates and laws expected
to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized
in income in the period that includes the enactment date. A valuation
allowance is provided unless realization of such assets is deemed more
likely than not.Cash and Cash EquivalentsFor purposes of the consolidated statements of cash flows, cash and cash
equivalents include cash held in banks and time deposits having maturities
within three months of the date of purchase by the Company.GoodwillGoodwill, which represents the excess of purchase price over fair value of
net assets acquired, has been amortized on a straight-line basis over 10 to
15 years. As of December 31, 2000 the remaining goodwill related entirely
to the engineering design services business. This amount was written off
in 2001 connection with the disposal of the business (Note 4).Stock Option PlanThe Company accounts for its stock option plan in accordance with the
provisions of Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations.
As such, compensation expense is recorded on the date of grant only if the
current market price of the underlying stock exceeded the exercise price.
Statement of Financial Accounting Standards (SFAS) No. 123, Accounting
for Stock-Based Compensation, requires pro forma net income and pro forma
earnings per share disclosures for employee stock option grants as if the
fair-value-based method defined in SFAS No. 123 had been applied.Had the Company determined compensation cost based on the fair value on the
grant date for its stock options under SFAS No. 123, the Companys net
losses would have been increased to pro forma amounts as follows: Years ended December 31,2003
    
    2002
    
    2001$ (in Thousands)Net loss allocable to
common shareholders:As reported
    
    $
    (8,559
    )
    
    $
    (4,350
    )
    
    $
    (21,549
    )Additional compensation
expense
    
    
    693
    
    
    
    1,055
    
    
    
    1,202Pro forma
    
    $
    (9,252
    )
    
    $
    (5,405
    )
    
    $
    (22,751
    )Loss per share (basic and diluted):As reported
    
    $
    (0.07
    )
    
    $
    (0.05
    )
    
    $
    (0.25
    )Pro forma
    
    $
    (0.08
    )
    
    $
    (0.06
    )
    
    $
    (0.26
    )
 38




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  ReclassificationCertain prior period balances have been reclassified to conform to the
current year presentation.(3)
    
    Liquidity MattersThe Company has incurred significant operating losses in 2003, 2002 and
2001; however, the amount of these losses has decreased in each of those
years. The Companys operating losses have been funded over the past three
years with the proceeds from the sale of debt and equity securities,
proceeds from borrowings, proceeds from the sale of assets and, in 2002,
with proceeds from the settlement of certain litigationThe decrease in operating losses is the result of the disposal of certain
operations, specifically those related to the telecommunications industry,
the reduction of other operating expenses and increases in net revenues
from the Companys defense electronics business. Net revenues from the
sale of defense electronic products have increased in each of the last
three years. Management expects net revenues to increase further in 2004
and as a result that it will generate cash from operating activities during
2004. There can be no assurance, however, that net revenues will increase
or will increase to the extent anticipated and that the Company will
generate sufficient cash from operating activities.Should the Company not generate sufficient cash from operating activities
the Company could require additional capital. The Company believes that it
will be able to raise additional capital through either the issuance of new
equity securities, the incurrence of new debt or the modification of the
terms of its existing debt obligations. There can be no assurance that the
Company can accomplish these matters, or can do so under acceptable terms.
These financial statements do not include any adjustments that might result
from the outcome of this uncertainty.(4)
    
    Discontinued OperationsAs of December 31, 2001 the Company had commenced a plan to dispose of its
engineering design services business. In January 2002 substantially all of
the assets related to this business were sold to Flextronics International,
Ltd. (Flextronics). Proceeds from the sale amounted to $2,800,000 and
consisted of $1,660,000 in cash at closing, a hold-back of $140,000 which
was paid six months after the closing and a hold-back of $1,000,000 to be
applied against amounts due to Flextronics pursuant to the design services
agreement discussed below. In conjunction with the sale, the Company and
Flextronics entered into a design services agreement whereby the Company
agreed to purchase and Flextronics agreed to provide a specified number of
hours of engineering design services over the next year. Such services
were charged at agreed upon rates and aggregated approximately $1,000,000.
As of December 31, 2003 the Company had utilized the full amount of these
services.The disposal of these operations has resulted in a loss of $956,000 which
has been recognized as of December 31, 2001. The loss includes the loss
from operations of the design services business from December 31, 2001 to
the date of disposal, certain costs associated with the disposal and costs
associated with a real estate lease related to those operations.
Approximately one year of lease costs, or $249,000 has been charged to the
discontinued operationsIn the third quarter of 2002 the company reached an agreement in principle
regarding certain indemnification obligations to Savage Sports Corporation
(Savage Sports)(see Note 15). Under the agreement, the
Company will pay Savage Sports a total of $1,575,000 over a four-year
period. Also under 39




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  the agreement, Savage Sports will fund the cost of
insurance programs that are expected to respond to any other such claims
that may arise. The Company recorded a charge of $1,520,000 related to
this matter in the third quarter of 2002 as a loss from discontinued
operations. At December 31, 2003 $1,350,000 is payable under this
arrangement of which $600,000 is due after 2004.(5)
    
    Subsequent EventSubsequent to December 31, 2003, the Company effected an amendment to its
$4,200,000 guaranteed bank facility (see Note 9) to extend the maturity of
the facility. Amounts available under the facility will be reduced by
$300,000 on June 30, 2004 and December 31, 2004, respectively. All amounts
outstanding under the facility are now due April 27, 2005.(6)
    
    Investment in AffiliateOn August 30, 2001 the Company completed the sale of essentially all of the
assets related to the OmniLynx product line to ITI, which is a corporation
owned by Singapore Technologies Electronics Ltd. (STE) and the Company.
Concurrent with the sale of the assets the Company contributed $1,250,000
to ITI for its 33% equity interest. The Company has minority board of
director representation in ITI and exercises no day-to-day control over the
operations of ITI; therefore, the Company accounts for its equity interest
using the equity method of accounting. In February 2003 STE purchased
additional shares of ITI common stock for $1,500,000. Subsequent to this
transaction the Company owns approximately 22% of ITIs common stock.The Company has reached an agreement in principle with a third party to
sell all of its ITI common stock and settle all amounts due from and to ITI
for a cash payment of $250,000. Accordingly, the Company has written-off
its receivable from ITI and has reduced the amount of its investment in ITI
to $250,000.(7)
    
    InventoriesThe components of inventories are as follows (in thousands): December 31,2003
    
    2002Raw materials
    
    
    
    
    
    $
    949
    
    
    $
    1,658Work in progress
    
    
    
    
    
    
    304
    
    
    
    408Finished goods
    
    
    
    
    
    
    342
    
    
    
    288Total
    
    
    
    $
    1,595
    
    
    $
    2,354
 40




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  (8)
    
    Property and EquipmentProperty and equipment are summarized as follows (in thousands): December 31,2003
    
    2002Machinery and equipment
    
    $
    1,072
    
    
    $
    1,048Computer equipment
    
    
    304
    
    
    
    297Software
    
    
    388
    
    
    
    388Furniture and fixtures
    
    
    144
    
    
    
    144Leasehold improvements
    
    
    101
    
    
    
    1012,009
    
    
    
    1,978Less:Accumulated depreciation and amortization
    
    
    (1,631
    )
    
    
    (1,405
    )Total
    
    $
    378
    
    
    $
    573
  (9)
    
    Notes payableNotes payable consist of the following (in thousands): December 31,2003
    
    2002Guaranteed bank facility (A)
    
    $
    4,200
    
    
    $
    4,20012% convertible subordinate notes (B)
    
    
    3,130
    
    
    
    Short-term note (A)
    
    
    
    
    
    
    647Subsidiary
revolving credit facility (C)
    
    
    
    
    
    
    Other (D)
    
    
    100
    
    
    
    1007,430
    
    
    
    4,947Amount due within one year
    
    
    (700
    )
    
    
    (4,047
    )Unamortized discount
    
    
    (821
    )
    
    
    Amount due after one year
    
    $
    5,909
    
    
    $
    900
 (A) In June 2003 the Company entered into an amended loan agreement with
Bank One, N.A. (Bank One) which provides for borrowings of up to
$4,200,000 on a revolving basis All amounts outstanding under this
facility are due April 27, 2005. Interest is payable monthly at LIBOR plus
1.75% (2.87% at December 31, 2003). This facility is secured by a
$4,500,000 letter of credit provided by a private investor. In March 2004, this credit facility was amended to provide for a maturity
of April 30, 2005. The maximum amount available under the facility will
be reduced by $300,000 on June 30, 2004 and December 31, 2004,
respectively. The letter of credit securing the facility was extended to
reflect the increased maturity. As consideration for this extension, the
Company issued warrants to the private investor. The warrants provide for
the purchase of 3,250,000 shares of the Companys common stock at a price
of $0.29 per share and 3,250,000 shares of the Companys common stock at a
price of $0.55 per share. The warrants are exercisable at any time
through April 30, 2006. (see Note 5). The fair value of these warrants
is
approximately $190,000 using the Black-Scholes pricing model. This amount
will be amortized over the term of the loan and included in interest
expense. 41




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued) In connection with the letter of credit and guaranty of the above
facility, the Company entered into reimbursement agreements with the
private investor providing the security. The agreement provides that the
Company will reimburse the securing party for any costs associated with
the letters of credit and guaranty, including any amounts which the party
may be required to fund to the bank. The Company has agreed to grant a
security interest in certain accounts receivable and inventories in the
event they must fund amounts to the bank. In addition, the Company has
agreed not to pledge certain of its assets or to incur certain
indebtedness in excess of $1,000,000 without the consent of the securing
party. As consideration for initially providing this security, the
Company issued warrants for the purchase of the Companys common stock to
the securing party and amended certain other warrants previously held by
the party. The new and amended warrants provide for the purchase of up to
2,790,000 shares of the Companys common stock at a price of $0.12 per
share. The warrants generally expire in October 2004. The fair value of
the new warrants and the amendment to the existing warrants is
approximately $200,000 using the Black-Scholes pricing model. This amount
is being amortized over the average term of the loans and is included in
interest expense. The private investor providing security for the loan agreements described
above, also provided the Company with cash advances pursuant to a series
of short-term notes. In October 2003, this investor agreed to cancel the
note and accrued interest totaling approximately $700,000 in exchange for
2,800,000 shares of the Companys common stock and the extension of the
maturity date of common stock warrants previously issued to the investor.
Warrants for the purchase of an aggregate of 2,790,000 shares of common
stock at a price of $0.12 per share had been issued in connection with
previous financing transactions discussed above. The expiration dates of
the warrants, which ranged from December 31, 2003 to October 31, 2004,
have been extended to October 31, 2005. The extension of
maturity dates had an estimated value of $121,000, which has been included in interest expense in 2003. (B) In July and August 2003, the Company issued $3,010,000 principal
amount of 12% convertible subordinated notes in a private placement to
qualified investors and $250,000 principal amount of such notes to an
officer and a director, both related parties. The purchasers of the notes
also received warrants to purchase 2,037,500 shares of the common stock at
$0.16 per share. Net proceeds to the Company, after paying commissions to
the placement agent and legal costs, amounted to approximately $3,059,000
which will be used for working capital. The Company also issued warrants
for the purchase of 1,881,250 shares of common stock to the placement
agent for the notes. The Company has valued the warrants issued in this
transaction at approximately $258,000 using the Black-Scholes pricing
model. This amount and a beneficial conversion feature in the amount of
approximately $870,000 have been recorded as discount on debt. The notes are subordinated unsecured obligations of the Company and are
subordinated to the rights of holders of all existing and future senior
indebtedness. The terms of the Note Agreement limit the ability of the
Company to incur additional senior indebtedness. Pursuant to the Note
Agreement, the Company shall not directly or indirectly create, incur or
suffer to exist any indebtedness senior to the Notes (Senior
Indebtedness) in an aggregate principal amount exceeding at any time the
sum of one million dollars ($1,000,000) without the prior written consent
of at least 51% of the aggregate principal amount of the Notes outstanding
at the time the transaction is authorized by the Companys board of
directors. For purposes of calculating the limitation on incurring Senior
Indebtedness, the following indebtedness shall not be included in
calculating the aggregate amount of Senior Indebtedness: (a) Bank One, NA
in the amount of $4.2 million, (b) a private investor in the amount of
$650,000, (c) FirstCapital Bank, SSB in the 42




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued) amount of $1,000,000, and (d)
any restructuring or refinancing of the Senior Indebtedness described in
(a), (b) and (c). The Company will pay all outstanding principal balances on the Notes at
maturity, which is June 30, 2005. Interest on the Notes will accrue at a
rate of 12% per annum, computed on the basis of a 360-day year of twelve
30-day months. Interest will be due annually on June 15 and at maturity
on June 30, 2005. The Company may redeem all or any portion of the
outstanding Notes at any time. Each Note to be so redeemed shall be
redeemed against payment of an amount in cash equal to: 110% of the
outstanding principal balance of the Note, plus accrued interest, if
redeemed after June 15, 2003 but on or before June 1, 2004, and 105% of
the outstanding principal balance of the Note, plus accrued interest, if
redeemed after June 1, 2004. A note holder may convert any or all of the principal and accrued interest
of his Notes into shares of common stock at any time. The number of
shares of common stock issuable upon conversion shall be determined by
dividing the outstanding indebtedness and accrued interest to be converted
by the conversion price in effect at the time of conversion. The initial
conversion price of the Notes is $0.16 per share. The conversion price is
subject to anti-dilution provisions and therefore may be adjusted from
time to time upon the occurrence of certain events. The number of shares to be issued upon exercise of the Warrants to the
purchasers of the notes and the placement agent is subject to
anti-dilution provisions and therefore may be adjusted from time to time.
The exercise price of the Warrants is equal to the conversion price of the
notes upon the closing of this offering, which was $0.16 per share. The
initial exercise price will be subject to anti-dilution provisions and
therefore may be adjusted from time to time upon the occurrence of certain
events. The warrants may be exercised at the option of the holder at any
time prior to their expiration. The warrants will expire four years after
their issuance. As of December 31, 2003 notes with a principal amount of $130,000 had been
converted into common stock. (C) In March 2003, the Company and DCS entered into a $1,000,000 revolving
line of credit with First Capital Bank, SSB This working capital facility was secured by the accounts receivable and
inventory of DCS, the guarantee of the Company and by limited guarantees
provided by certain private investors. As consideration for providing the
guarantees that secure the facility, the Company has entered into a
Reimbursement Agreement with the guarantors. The Reimbursement Agreement
provides that the Company will reimburse the investors for any amounts
that they may be required to reimburse the bank pursuant to the
guarantees. Pursuant to the Reimbursement Agreement and related
agreements, the investors have the right to purchase up to 8,333,333
shares of the Companys common stock for $1,000,000 in cash, the proceeds
of which will be used to repay amounts outstanding under the facility and
provide for the release of the guarantees. In addition, the investors
received warrants to purchase an aggregate of 9,583,333 shares of the
Companys common stock at a price of $0.15 per share. The warrants may be
exercised at any time through March 31, 2007. The Company has valued the
warrants at approximately $360,000, using the Black-Scholes pricing model.
This amount and a beneficial conversion feature in the amount of
approximately $408,000 related to the purchase rights have been recorded
as deferred financing costs. In October 2003 the investors exercised their conversion rights under the
Reimbursement Agreement. The Company issued 8,333,333 shares of common
stock in exchange for $1,000,000 cash, which was used to 43




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued) repay all amounts
outstanding under the line of credit. The line of credit was then
cancelled and all collateral and guarantees were released by the bank. (D) Consists of $100,000 payable to an officer and director, a related
party, under a demand note bearing interest of prime plus 3%. This note
may be converted into common stock at the option of the holder at the rate
of $1.00 per share.  (10)
    
    CommitmentsLeases The Company leases office space and certain equipment under leases expiring
at various dates through 2008. Rental expense under operating leases was
approximately $591,000, $791,000, and $1,284,000 for the years ended
December 31, 2003, 2002 and 2001, respectively.Future minimum commitments as of December 31, 2003 under operating leases
are as follows (in
thousands). Years ending December 31,2004
    
    $
    2842005
    
    
    2242006
    
    
    2172007
    
    
    2222008 and thereafter
    
    
    246Total minimum lease payments
    
    $
    1,193
  As of December 31, 2003 the Company had outstanding non-cancelable purchase
orders totaling approximately $875,000 related to the purchase of
components and sub-assemblies.(11)
    
    Employee Benefit PlansThe Company sponsors defined contribution 401(k) plans for substantially
all employees. Pursuant to the plans, employees may request the Company to
deduct and contribute amounts from their salary on a pre-tax basis.
Employee contributions are subject to certain limitations and the Company
may make matching contributions, at its discretion. The Company may also
make discretionary contributions in addition to matching contributions.
Company contributions vest ratably over periods of four to five years,
beginning in the second or first year of employment, respectively. Company
contributions to the plans were $91,000, $136,000 and $158,000 for the
years ended December 31, 2003, 2002 and 2001, respectively. 44




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  (12)
    
    Income TaxesThe difference between the actual income tax benefit and the benefit
computed by applying the statutory corporate income tax rate of 34% to
pretax losses from continuing operations is attributable to the following
(in thousands): Years ended December 31,2003
    
    2002
    
    2001Computed expected tax benefit
    
    $
    (2,910
    )
    
    $
    (1,479
    )
    
    $
    (7,327
    )Increase in valuation allowance
    
    
    1,487
    
    
    
    (168
    )
    
    
    7,187Non-deductible expenses
    
    
    535
    
    
    
    222
    
    
    
    230Other
    
    
    888
    
    
    
    1,425
    
    
    
    (90
    )Tax expense
    
    $
    
    
    
    $
    
    
    
    $
    
  The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities at
December 31, 2003 and 2002 are as follows (in thousands): December 31,2003
    
    2002Deferred tax assets:Net operating loss carryforwards
    
    $
    58,406
    
    
    $
    57,574Accounts receivable
    
    
    163
    
    
    
    Inventories
    
    
    259
    
    
    
    261Accrued liabilities
    
    
    1,267
    
    
    
    785Alternative minimum tax and other credit
carryforwards
    
    
    38
    
    
    
    38Other
    
    
    (30
    )
    
    
    360,103
    
    
    
    58,661Less valuation allowance
    
    
    (60,103
    )
    
    
    (58,616
    )Deferred tax assets
    
    $
    
    
    
    $
    45Deferred tax liabilities
    
    
    
    
    
    
    (45
    )$
    
    
    
    $
    
  At December 31, 2003, the Company had federal operating loss carryforwards
of approximately $171,645,000. Following is a summary of the carryforwards
and the expiration dates as of December 31, 2003 (in thousands): Amounts
    
    Expiration Dates$
    3,454
    
    
    
    2007$
    6,216
    
    
    
    2008$
    1,972
    
    
    
    2009$
    4,118
    
    
    
    2010$
    155,885
    
    
    2011 and after
 45




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  (13)
    
    Warrant IssuancesThe Company has issued various series of warrants in connection with debt
and equity financings, and as compensation for investment banking and other
services. As of December 31, 2003 there were outstanding warrants to
purchase 21,854,816 shares of the Companys common stock as follows: Shares Subject to Warrants
    
    Exercise Price
    
    Expiration Date199,400
    
    
    $
    0.09
    
    
    
    20043,670,000
    
    
    $
    0.12
    
    
    
    2004-200513,916,666
    
    
    $
    0.15
    
    
    
    20073,918,750
    
    
    $
    0.16
    
    
    
    2006150,000
    
    
    $
    2.00
    
    
    
    2004
  All of the warrants outstanding above are exercisable. In December 2003,
warrants for the purchase of 300,000 shares of common stock were exercised,
resulting in net proceeds to the Company of approximately $36,000.The issuance of warrants during the three year period ended December 31,
2003 is as follows:2003In March 2003, the Company issued warrants for the purchase of 4,333,333
shares of common stock in connection with a private placement of common
stock. The Company also issued  warrants for the purchase of 9,583,333 shares of common stock in
connection with a debt financing transaction (see Note 9). These warrants
expire in March 2007 and have an exercise price of $0.15 per share.In July and August 2003, the Company issued warrants for the purchase of a
total of 3,918,750 shares of common stock in connection with the issuance
of its 12% Convertible Subordinated Notes Due June 2005 (see Note 9).
All of these warrants expire in June 2006 and have an exercise price of $0.16 per
share.2002In April 2002 warrants for the purchase of 26,017,308 shares of common
stock were returned to the Company and cancelled in exchange for the
issuance of 2,000,000 shares of common stock. These warrants had an
exercise price of $0.75 per share and stated expiration dates ranging from
2002 to 2004.In October 2002 the Company issued warrants for the purchase of 400,000
shares of common stock at $0.12 per share exercisable through September,
2005 and amended certain other warrants for the purchase of an aggregate of
780,000 shares of common stock to reduce the exercise price from $0.75 per
share to $0.12 per share. The amended warrants expire in 2003 and 2004.
These transactions were in connection with the sale of 16,666,668 shares of
common stock in a private placement, the proceeds of which were used to
repay $2,000,000 in notes payable (see Note 9). The Company has valued the
warrants issued and the effect of the repricing at $307,000 using the
Black-Scholes option pricing model. This amount has been recorded as a
deferred financing cost.In connection with the restructuring and extension of certain notes
payable, the Company in December, 2002 issued warrants for the purchase of
960,000 shares of common stock at $0.12 per share through October,
2004. In connection with this transaction the Company also amended
warrants for the purchase of an 46




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  aggregate of 1,830,000 shares of common
stock to provide for an exercise price of $0.12 per share. These warrants,
which expire at various dates in 2003 and 2004, previously had exercise
prices of from $0.20 per share to $0.80 per share (see Note 9).2001In June, 2001 and October, 2001, the Company issued warrants for the
purchase of an aggregate of 2,160,000 shares of common stock in connection
with certain credit arrangements (see Note 9).(14)
    
    Employee Stock Option PlanIn 1995, the Company adopted a stock option plan (the Plan) pursuant to
which the Companys Board of Directors may grant stock options to
directors, officers and key employees. The Plan, as amended, authorizes
grants of options to purchase up to 15,500,000 shares of authorized common
stock. The exercise price for stock options granted may range from 75% to
110% of the fair market value of the shares on the date of grant. All
stock options have 10-year terms and vest and become fully exercisable
according to schedules determined by the Board of Directors, generally
one-third on each of the first three anniversaries of the date of grant.
At December 31, 2003, there were approximately 683,000 shares available for
grant under the Plan. The Plan replaced a predecessor plan that continues
only to the extent that there are 40,000 unexercised options outstanding at
December 31, 2003.The weighted-average fair value per share of stock options granted during
2003, 2002 and 2001 was $0.09, $0.16 and 0.44, respectively, on the dates
of grants. The fair value of each option grant is estimated on the date of
grant using the Black-Scholes option pricing model, with the following
weighted-average assumptions: Years ended December 31,2003
    
    2002
    
    2001Expected dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Stock price volatility
    
    
    72
    %
    
    
    130
    %
    
    
    150
    %Risk free interest rate
    
    
    2.5
    %
    
    1.67% to 3.5%
    
    4.8% to 5.4%Expected option term
    
    3 years
    
    7 years
    
    7 years
  Stock option activity during the periods indicated was as follows: Years ended December 31,2003
    
    2002
    
    2001Number of options:Outstanding, beginning of
period
    
    
    10,766,000
    
    
    
    6,268,468
    
    
    
    5,530,305Granted
    
    
    3,170,000
    
    
    
    5,621,500
    
    
    
    1,917,000Exercised
    
    
    (134,402
    )
    
    
    
    
    
    
    Canceled
    
    
    (1,218,261
    )
    
    
    (1,123,968
    )
    
    
    (1,178,837
    )Outstanding, end of period
    
    
    12,583,337
    
    
    
    10,766,000
    
    
    
    6,268,468
 47




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued) Weighted average exercise price:Outstanding, beginning of period
    
    $
    0.59
    
    
    $
    1.15
    
    
    $
    1.50Granted
    
    $
    0.19
    
    
    $
    0.16
    
    
    $
    0.44Exercised
    
    $
    0.16
    
    
    $
    
    
    
    $
    Canceled
    
    $
    0.73
    
    
    $
    1.58
    
    
    $
    1.62Outstanding, end of period
    
    $
    0.48
    
    
    $
    0.59
    
    
    $
    1.15
  At December 31, 2003, 2002 and 2001, the number of options exercisable was
9,508,553, 7,537,222 and 3,724,046, respectively, and the weighted-average
exercise price of those options was $0.57, $0.95 and $1.40, respectively.Additional information with respect to options outstanding at December 31,
2003 is as follows: Options outstanding
    
    Options exercisableWeighted average
    
    Option
    
    Weighted average
    
    Option
    
    Weighted averageExercise prices
    
    remaining
    
    shares
    
    exercise
    
    shares
    
    exerciseper share
    
    contractual life
    
    outstanding
    
    price
    
    exercisable
    
    price$0.160-$0.170
    
    8.74 years
    
    
    5,786,500
    
    
    $
    0.161
    
    
    
    4,058,625
    
    
    $
    0.160$0.180-$0.531
    
    8.66 years
    
    
    3,419,337
    
    
    $
    0.279
    
    
    
    2,114,097
    
    
    $
    0.319$0.532-$3.156
    
    5.91 years
    
    
    3,377,500
    
    
    $
    1.234
    
    
    
    3,335,831
    
    
    $
    1.24212,583,337
    
    
    
    
    
    
    
    9,508,553
  (15)
    
    ContingenciesA shareholder class action lawsuit was filed in the U. S. District Court
for the Northern District of Texas in November 1999 on behalf of all
persons and entities who purchased the Companys common stock during the
period between February 24, 1998 and November 17, 1998. The named
defendants include the Company and certain former and present officers and
directors of the Company. The complaint alleges that the defendants
violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934
and Rule 10b-5 promulgated thereunder by making false and misleading
statements concerning the Companys reported financial results during the
period, primarily relating to revenue recognition, asset impairment and
capitalization issues. The plaintiffs seek monetary damages, interest,
costs and expenses. In March 2001, the Companys motion to dismiss the
case was denied. In December 2002, the Court denied the plaintiffs motion
for class certification. The plaintiffs appealed this ruling to the 5th
Circuit Court of Appeals and in March 2003 the appellate court refused to
hear the appeal. After additional discovery and certain rulings by the
Court, the complaint is now pending with 12 individual plaintiffs. The
Company has reached agreement in principle with each of the plaintiffs to
settle the matter. Pursuant to the settlement arrangements the Company
will make payments aggregating approximately $185,000. Completion of the
settlements is pending preparation of settlement and release documents and
approval of the settlement by the Court.Zurich American Insurance Company (Zurich) provides excess liability
coverage of up to $3,000,000, for amounts in excess of $2,000,000 related
to this matter. The Company estimates that the total costs related to 48




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  this matter will not invoke the coverage provided by Zurich. Nonetheless,
Zurich has agreed to advance to us the approximately $185,000 in settlement
payments. Any such amounts advanced will be evidenced by a note payable to
Zurich, payable in two years and will bear interest at 7% per annum,
payable at maturity. The note will be secured by warrants to purchase shares of the Companys common stock.Reliance Insurance Company (Reliance) provides the primary $2,000,000 of
insurance coverage for this matter. Reliance has been ordered liquidated
by the insurance commissioner of the State of Pennsylvania. The Company
has previously received $300,000 from the Texas Property and Casualty
Guaranty Association related to this claim. The Company estimates that it
has a claim against Reliance of approximately $1,600,000 and has filed a
proof of claim for this amount with the Statutory Liquidator for Reliance.
The amount of such recovery cannot be estimated at this time and there is
no assurance as to any recovery. In addition, the timing of any recovery
is uncertain and could be a matter of years. Accordingly, no such recovery
has been reflected in the accompanying financial statements.The Company is contingently liable for certain potential claims that arise
out of Savage Arms, Inc., a manufacturer of sporting bolt action rifles
(Savage Arms). The Company sold Savage Arms to the Savage Sports
Corporation (Savage Sports), and pursuant to the Stock Purchase Agreement
executed on October 3, 1995, agreed to indemnify Savage Sports for certain
product liability claims, environmental clean-up costs and other
contractual liabilities, including certain asserted successor liability
claims, that Savage Sports incurred because of Savage Arms.In October, 2002 the Company reached an agreement in principle with Savage
regarding all indemnification matters, including the balance of amounts due
Savage pursuant to a previous settlement agreement reached in January,
2001. Under this agreement the Company has agreed to pay Savage a total of
$1,575,000, which includes the remaining balance of the prior settlement,
over a four year period. Savage has agreed to fund the cost of insurance
programs that are expected to respond to any other such claim that may
arise in the future. The Company is aware of no such claims and Savage has
advised us that they are not aware of any additional claims. The Company
recorded a charge of $1,520,000 related to this matter in the third quarter
of 2002.In March 2002, the Company entered into an agreement with LaBarge, Inc.
(LaBarge) for the development and manufacture of a conduction cooled
version of a certain model of its VQG4 product. In January 2003, the
Company terminated the contract due to its believe that LaBarge did not
fully perform under the contract and defaulted. Subsequent to January
2003, the Company engaged in a series of discussions with LaBarge regarding
the settlement of outstanding issues, including claims of monies owed. In
October 2003 litigation was commenced in the Circuit Court of the County of
St. Louis in the State of Missouri. In these proceedings LaBarge has
alleged that the Company improperly terminated the contract and seeks
recovery costs and lost profits amounting to approximately $700,000. The
Company has alleged that LaBarge breached the contract and is seeking
recovery of amounts previously paid to LaBarge, costs incurred resulting
from the breach and lost profits. Such items aggregate in excess of
$1,000,000. The ultimate resolution of this matter cannot be determined at
this time. 49




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  (16)
    
    Segments of Business and Geographic AreasThe Companys primary business segment consists of defense electronics
formerly referred to as digital signal processor (or DSP) in which the
Company provides state-of-the-art digital processing products to product
manufacturers and application developers. Prior to 2002 the Company was
also actively engaged in the design, production and sale of optical
networking equipment. Substantially all the assets of this business were
sold in 2001 to an entity in which the Company retains a minority interest
(see Note 6).The accounting policies of the segments are the same as those described in
the significant accounting policies and practices (see Note 2).Sales to external customers (in thousands): Years ended December 31,2003
    
    2002
    
    2001Defense electronics
    
    $
    6,207
    
    
    $
    5,036
    
    
    $
    4,195Optical networking equipment
    
    
    
    
    
    
    
    
    
    
    2,368Other
    
    
    
    
    
    
    
    
    
    
    259Total
    
    $
    6,207
    
    
    $
    5,036
    
    
    $
    6,822Included in the above were direct and indirect export sales of (in
thousands):Total
    
    $
    884
    
    
    $
    183
    
    
    $
    863
  Segment-specific margins (gross profit less total engineering and
development costs, including capitalized software, and asset write downs
for the segment) (in thousands): Years ended December 31,2003
    
    2002
    
    2001Defense electronics
    
    $
    (2,409
    )
    
    $
    (2,908
    )
    
    $
    (4,141
    )Optical networking equipment
    
    
    
    
    
    
    (84
    )
    
    
    (3,026
    )Other
    
    
    
    
    
    
    (178
    )
    
    
    (2,192
    )Subtotal segment specific
    
    
    (2,409
    )
    
    
    (3,170
    )
    
    
    (9,359
    )Capitalized software costs
    
    
    
    
    
    
    
    
    
    
    All other expenses
    
    
    (3,112
    )
    
    
    (4,065
    )
    
    
    (7,365
    )Operating loss
    
    $
    (5,521
    )
    
    $
    (7,235
    )
    
    $
    (16,724
    )
 50




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  Assets, capital expenditures and depreciation (in thousands): At December 31,2003
    
    2002
    
    2001ASSETSDefense electronics
    
    $
    4,506
    
    
    $
    3,760
    
    
    $
    4,052Optical networking equipment
and other
    
    
    300
    
    
    
    1,501
    
    
    
    2,625Not allocable to a segment
    
    
    542
    
    
    
    1,463
    
    
    
    3,519Total
    
    $
    5,348
    
    
    $
    6,724
    
    
    $
    10,196
 Years ended December 31,2003
    
    2002
    
    2001CAPITAL EXPENDITURESDefense electronics
    
    $
    29
    
    
    $
    176
    
    
    $
    83Optical networking equipment
and other
    
    
    
    
    
    
    
    
    
    
    Not allocable to a segment
    
    
    3
    
    
    
    3
    
    
    
    242Total
    
    
    32
    
    
    $
    179
    
    
    $
    325DEPRECIATIONDefense electronics
    
    $
    214
    
    
    $
    138
    
    
    $
    130Optical networking equipment
and other
    
    
    
    
    
    
    
    
    
    
    Not allocable to a segment
    
    
    13
    
    
    
    106
    
    
    
    528Total
    
    $
    227
    
    
    $
    244
    
    
    $
    658
  (17)
    
    Related Party TransactionsIn August 2003 the Company issued 12% Convertible Subordinated Notes Due
June 2005 with an aggregate principal balance of $250,000 to an officer and
a director in satisfaction of cash advances of the same amount that they
had made to the Company (see Note 9).A director of the Company provided a guarantee in the amount of $150,000 as
partial security for a revolving credit agreement with a bank (see
Note 9).
The director received conversion rights entitling him to purchase
1,250,000 shares of common stock at a price of $0.12 per share and warrants
to purchase 1,666,667 shares of common stock at a price of $0.15 per share.
In November 2003 the director, along with the other guarantors, exercised
his conversion rights and purchased 1,250,000 shares of common stock for
$150,000 cash. The proceeds were used to repay amounts outstanding under
the guaranteed bank facility.(18)
    
    Significant Customers and Concentration of Credit RiskIn 2003 four defense electronics customers accounted for 19%, 18%, 16% and
11%, respectively, of consolidated net revenues. In 2002 three defense
electronics customers accounted for 37%, 17% and 11%, respectively, of
consolidated net revenues. In 2001 one defense electronics customer
accounted for 37% of consolidated net revenues.  The Company is subject to credit risk through trade receivables. The
Companys customers are generally large prime or subcontractors that are
involved in providing products and services to agencies of the United
States. Sales terms are normally 30 to 45 days from date of shipment. 51




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(continued)  (19)
    
    Supplemental Disclosure of Cash Flow Information Years ended December 31,2003
    
    2002
    
    2001(in thousands)Cash paid during the period for:Interest
    
    $
    185
    
    
    $
    341
    
    
    $
    131
  Noncash Financing and Investment TransactionsDuring the years ended December 31, 2003, 2002 and 2001 the Company
recorded the following non-cash financing transactions:2003:  
    
    The Company issued 2,800,000 shares of common stock in exchange
for the cancellation of a note payable with outstanding principal and
interest totaling approximately $699,000.  2002:  
    
    The Company issued 2,000,000 shares of common stock in exchange
for warrants to purchase of total of 26,018,308 shares of common stock
(see Note 13).  2001:  
    
    The Company issued common stock in settlement of approximately
$387,000 due to certain former employees pursuant to retention and
termination agreements.  (20)
    
    Valuation and Qualifying Accounts AdditionsBalance at
    
    charged to costs
    
    Additions charged
    
    
    
    
    
    Balances at endbeginning of period
    
    and expenses
    
    to other accounts
    
    Deductions
    
    of period(In thousands)Allowance for doubtful accounts:For the year ended December 31,
2003
    
    $
    
    
    
    $
    30
    
    
    $
    
    
    
    $
    
    
    
    $
    30For the year ended December 31,
2002
    
    $
    1,606
    
    
    $
    46
    
    
    $
    
    
    
    $
    1,652
    
    
    $
    For the year ended December 31,
2001
    
    $
    1,460
    
    
    $
    285
    
    
    $
    
    
    
    $
    139
    
    
    $
    1,606
 52




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements
(concluded) (21) Quarterly Information (Unaudited) Quarter ended:March 31
    
    June 30
    
    September 30
    
    December 31(In thousands, except per share amounts)Year ended December 31, 2003:Net revenue
    
    $
    953
    
    
    $
    1,385
    
    
    $
    1,699
    
    
    $
    2,170Gross profit
    
    $
    273
    
    
    $
    408
    
    
    $
    591
    
    
    $
    937Net income (loss)
    
    $
    (2,191
    )
    
    $
    (1,887
    )
    
    $
    (2,659
    )
    
    $
    (1,822
    )Net income (loss) per share
    
    
    (0.02
    )
    
    
    (0.02
    )
    
    
    (0.02
    )
    
    
    (0.01
    )Year ended December 31, 2002:Net revenue
    
    $
    1,630
    
    
    $
    1,659
    
    
    $
    718
    
    
    $
    1,029Gross profit
    
    $
    871
    
    
    $
    699
    
    
    $
    93
    
    
    $
    39Income (loss) from
continuing operations
    
    $
    4,784
    
    
    $
    (2,067
    )
    
    $
    (2,554
    )
    
    $
    (2,993
    )Loss from discontinued
operations
    
    $
    
    
    
    $
    
    
    
    $
    1,520
    
    
    $
    Net income (loss)
    
    $
    4,784
    
    
    $
    (2,067
    )
    
    $
    (4,074
    )
    
    $
    (2,993
    )Net income (loss) per share
    
    
    0.06
    
    
    
    (0.02
    )
    
    
    (0.05
    )
    
    
    (0.03
    )
 53




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##### Table of Contents



ITEM 9  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE None. PART III 
 ITEM 9A  CONTROLS AND PROCEDURES The term disclosure controls and procedures is defined in Rules
13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, or the Exchange
Act. This term refers to the controls and procedures of a company that are
designed to ensure that information required to be disclosed by a company in
the reports that it files or submits under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified by the
Securities and Exchange Commission. Our management, including our Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of our disclosure controls and procedures as of the end of the period covered
by this annual report. Based upon that evaluation, our Chief Executive Officer
and Chief Financial Officer have concluded that our disclosure controls and
procedures were effective as of the end of the period covered by this annual
report. There were no changes to our internal control over financial reporting
during our last fiscal quarter that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting. 
 ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Company will file with the Securities and Exchange Commission a
definitive Proxy Statement
no later than 120 days after the close of its fiscal year ended December 31,
2003 (the Proxy Statement). The information required by this Item is
incorporated by reference from the Proxy Statement. We are preparing a comprehensive Code of Ethics, but have not yet formally
adopted it. Many of the items contemplated by the Code of Ethics are the
subject to our existing policies and procedures. For example, our employee
handbook, which all employees are required to read and adhere to, includes
sections covering confidentiality and trade secrets, confidentiality of work,
disclosure, harassment, insider trading and other provisions that might be
encompassed within a comprehensive Code of Ethics. Our Export Control Process
provides comprehensive guidance concerning the export of our products and
technology. Because a Code of Ethics may impact these existing policies and
procedures, and some of these are subject to third party review, we are
analyzing any changes before formally adopting a comprehensive Code of Ethics. 
 ITEM 11 EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference from
the Proxy Statement. 
 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS The information required by this Item is incorporated by reference from
the Proxy Statement. 
 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference from
the Proxy Statement. 
 ITEM 14 PRINCIPAL ACCOUNTING FEES AND SERVICES The information required by this Item is incorporated by reference from
the Proxy Statement. 54




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##### Table of Contents



PART IV 
 ITEM 15 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K A. The Financial Statements filed as part of this report are listed and
indexed on Page 29. Schedules other than those listed in the index have been
omitted because they are not applicable or the required information has been
included elsewhere in this report. B. Listed below are all Exhibits filed as part of this report. Certain
Exhibits are incorporated by reference to documents previously filed by the
Registrant with the Securities and Exchange Commission pursuant to Rule 12b-32
under the Securities Exchange Act of 1934, as amended. Exhibits which are
incorporated by reference are indicated by the information in the parenthetical
following such exhibit. Exhibit
    
    Description of Exhibit3.1
    
    Amended and Restated Certificate of Incorporation of the Company, filed as an exhibit to
the Companys Form 8-K filed on February 1, 2001 and incorporated herein by reference.3.2
    
    Amended and Restated By-laws of the Company, filed as an exhibit to the Companys
Annual Report on Form 10-K filed April 15, 2003 and incorporated herein by reference.3.3*
    
    Amendment to By-laws of the Company.4.1*
    
    Registration Rights Agreement between the Company and Coastal dated December 17, 1999.4.2
    
    Form of Amended and Restated Promissory Notes held by officer, convertible into
Common Stock of the Company at a rate of $1.00 per share filed as
an exhibit to the Companys Form 10-K filed on March 30, 2000 and
incorporated by reference herein.4.3
    
    Securities Purchase Agreement dated September 30, 2002 between the Company and
Morton A. Cohn and Fayez Sarofim, filed as an exhibit to the
Companys Form 8-K filed October 21, 2002 and incorporated by
reference herein.4.4
    
    Registration Rights Agreement dated September 30, 2002 between the Company and
Morton A. Cohn and Fayez Sarofim, filed as an exhibit to the
Companys Form 8-K filed October 21, 2002 and incorporated by
reference herein.4.5
    
    Form of Amended and Restated Warrant expiring May 31, 2004 with an exercise price of
$0.12 per share, filed as an exhibit to the Companys Form 8-K
filed October 21, 2002 and incorporated by reference herein.4.6
    
    Form of Warrant expiring October 31, 2004 with an exercise price of $0.12 per share, filed
as an exhibit to the Companys Form 8-K filed October 21, 2002 and
incorporated by reference herein.4.7
    
    Form of Amended and Restated Warrant expiring December 31, 2003 with an exercise price
of $0.12 per share, filed as an exhibit to the Companys Form 8-K
filed October 21, 2002 and incorporated by reference herein.4.8
    
    Warrant expiring October 31, 2004 with an exercise price of $0.12 per share, filed as an
exhibit to the Companys Form 8-K/A filed January 15, 2003 and
incorporated by reference herein.4.9
    
    Amended and Restated Warrant expiring October 31, 2004 with an exercise price of $0.12
per share, filed as an exhibit to the Companys Form 8-K/A filed
January 15, 2003 and incorporated by reference herein.4.10
    
    Amended and Restated Warrant expiring October 31, 2004 with an exercise price of $0.12
per share, filed as an exhibit to the Companys Form 8-K/A filed
January 15, 2003 and incorporated by reference herein.4.11
    
    Amended and Restated Warrant expiring May 31, 2004 with an exercise price of $0.12 per
share, filed as an exhibit to the Companys Form 8-K/A filed
January 15, 2003 and incorporated by reference herein.4.12
    
    Form of Registration Rights Agreement between the Company and certain
private investors,
 55




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##### Table of Contents



Exhibit
    
    Description of Exhibitfiled as an exhibit to the Companys Form 8-K/A filed January 15,
2003 and incorporated by reference herein.4.13
    
    Form of Securities Purchase Agreement dated September 30, 2002 between the Company
and certain private investors, filed as an exhibit to the Companys
Form 8-K/A filed November 13, 2002 and incorporated by reference
herein.4.14
    
    Form of Registration Rights Agreement dated September 30, 2002 between the Company
and certain private investors, filed as an exhibit to the Companys
Form 8-K/A filed November 13, 2002 and incorporated by reference
herein.4.15
    
    Form of Warrant expiring March 31, 2007, filed as an exhibit to the Companys Form 10-K
filed April 15, 2003 and incorporated herein by reference.4.16
    
    Form of Note Agreement dated July 3, 2003, filed as an exhibit to the Companys Form 8-K
filed July 30, 2003 and incorporated by reference herein.4.17
    
    Form of 12% Convertible Subordinated Note, filed as an exhibit to the Companys Form
8-K filed July 30, 2003 and incorporated by reference herein.4.18
    
    Form of Warrant Agreement, filed as an exhibit to the Companys Form 8-K filed July 30,
2003 and incorporated by reference herein.4.19
    
    Registration Rights Agreement dated July 3, 2003, filed as an exhibit to the Companys Form
8-K filed July 30, 2003 and incorporated by reference herein.4.20
    
    Warrant for the purchase of 1,834,375 shares of Common Stock issued to Odyssey Capital,
LLC, filed as an exhibit to the Companys Form 8-K/A filed August
8, 2003 and incorporated by reference herein.4.21*
    
    Warrant for the purchase of 3,250,000 shares of Common Stock with an
exercise price of $0.29.4.22*
    
    Warrant for the purchase of 3,250,000 shares of Common Stock with an
exercise price of $0.55.10.1**
    
    Employment Agreement between the Company and Herman Frietsch and Amendment
thereto filed as an exhibit to the Companys Form 10-K filed on
March 30, 2000 and incorporated by reference herein.10.2**
    
    Employment Agreement dated as of January 1, 2001 between the Company and
Eugene Helms filed as an exhibit to the Companys Form 10-K filed April
15, 2002 and incorporated by reference herein.10.3
    
    Lease Agreement between Campbell Place One Joint Venture and DNA
Enterprises, dated February 1, 1997 filed as an exhibit to the Companys
Form 10-K filed April 15, 2003 and incorporated by reference herein.10.4
    
    Agreement to Form Joint Venture dated August 17, 2001 between the Company
and Singapore Technologies Electronics Limited filed as an exhibit to the
Companys Form 8-K filed September 7, 2001 and incorporated by reference
herein.10.5
    
    Sharing Agreement dated August 30, 2001 among the Company, Intelect
Network Technologies Company and Intelect Technologies Inc. filed as an
exhibit to the Companys Form 8-K filed September 7, 2001 and incorporated
by reference herein.10.6
    
    Stockholders Agreement dated August 30, 2001 among the Company, Intelect
Technologies Inc. and Singapore Technologies Electronics Limited filed as
an exhibit to the Companys Form 8-K filed September 7, 2001 and
incorporated by reference herein.10.7
    
    Transition Services Agreement dated August 30, 2001 between the Company
and Intelect Technologies Inc. filed as an exhibit to the Companys Form
8-K filed September 7, 2001 and incorporated by reference herein.10.8
    
    Asset Purchase Agreement dated January 11, 2002 among the Company,
Flextronics Design S.D., Inc. and DNA Enterprises, Inc. filed as an
exhibit to the Companys Form 8-K filed January 15, 2002 and incorporated
by reference herein.10.9
    
    Design / Engineering Services Agreement dated January 11, 2002 between
the Company and Flextronics Design S.D. filed as an exhibit to the
Companys Form 8-K filed January 15, 2002 and incorporated by reference
herein.10.10
    
    Form of Promissory Note dated June 1, 2001 in favor of Bank One, N.A.
filed as an exhibit to the Companys Form 10-Q filed August 14, 2001 and
incorporated by reference herein.
 56




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##### Table of Contents



Exhibit
    
    Description of Exhibit10.11
    
    Business Loan Agreement dated June 1, 2001 between the Company and Bank
One, N.A. filed as an exhibit to the Companys Form 10-Q filed August 14,
2001 and incorporated by reference herein.10.12
    
    Promissory Note dated November 30, 2001 filed as an exhibit to the
Companys Form 10-K filed April 15, 2002 and incorporated by reference
herein.10.13
    
    Promissory Note dated December 14, 2001 filed as an exhibit to the
Companys Form 10-K filed April 15, 2002 and incorporated by reference
herein.10.14
    
    Promissory Note dated February 11, 2002 filed as an exhibit to the
Companys Form 10-K filed April 15, 2002 and incorporate by reference
herein.10.15**
    
    Employment Agreement dated January 1, 2001 between the Company and
Robert P. Capps filed as an exhibit to the Companys Form 10-K filed April
15, 2002 and incorporated by reference herein.10.16
    
    Release and Settlement Agreement dated January 19, 2001 between the
Company and Savage Arms, Inc. filed as an exhibit to the Companys Form
10-K filed April 15, 2002 and incorporated by reference herein.10.17
    
    Settlement and Release Agreement dated March 4, 2002 among the Company,
DNA Enterprises, Inc. and Cadence Design Systems, Inc. filed as an exhibit
to the Companys Form 10-K filed April 15, 2002 and incorporated by
reference herein.10.18**
    
    Amended and Restated Stock Incentive Plan filed as an exhibit to the
Companys Definitive Proxy Statement filed on April 30, 2001 and
incorporated by reference herein.10.19
    
    Amendment to Credit Agreement dated October 3, 2002 between the Company
and Bank One, NA, filed as an exhibit to the Companys Form 8-K filed
October 21, 2002 and incorporated by reference herein.10.20
    
    Reimbursement Agreement by and between the Company and O.S. Wyatt, Jr.
dated as of December 30, 2002, filed as an exhibit to the Companys Form
8-K/A filed January 15, 2003 and incorporated by reference herein.10.21
    
    Promissory Note dated October 1, 2002, filed as an exhibit to the
Companys Form 8-K/A filed January 15, 2003, and incorporated by reference
herein.10.22
    
    Reimbursement Agreement dated March 26, 2003, filed as an exhibit to the
Companys Current Report on Form 8-K filed March 28, 2003 and incorporated
herein by reference.10.23
    
    Loan Agreement dated March 26, 2003 between DNA Computing Solutions,
Inc. and FirstCapital Bank, SSB, filed as an exhibit to the Companys
Annual Report on Form 10-K filed on April 15, 2003, and incorporated
herein by reference.10.24
    
    Note Modification Agreement dated March 31, 2003 between the Company and
Bank One, NA, filed as an exhibit to the Companys Annual Report on Form
10-K filed on April 15, 2003, and incorporated herein by reference.10.25
    
    Form of Note Agreement dated July 3, 2003, filed as an exhibit to the
Companys Form 8-K filed July 30, 2003 and incorporated by reference
herein.10.26
    
    Form of 12% Convertible Subordinated Note, filed as an exhibit to the
Companys Form 8-K filed July 30, 2003 and incorporated by reference
herein.10.27
    
    Technology License and Marketing Agreement between DNA Computing
Solutions, Inc. and VISTA Controls, Inc., filed as an exhibit to the
Companys Form 8-K filed November 24, 2003 and incorporated by reference
herein.10.28
    
    Distribution Agreement between DNA Computing Solutions, Inc. and VISTA
Controls, Inc., filed as an exhibit to the Companys Form 8-K filed
November 24, 2003 and incorporated by reference herein.10.29
    
    Technology Transfer and Support Agreement between DNA Computing
Solutions, Inc. and VISTA Controls, Inc., filed as an exhibit to the
Companys Form 8-K filed November 24, 2003 and incorporated by reference
herein.10.30* **
    
    Amended and Restated Stock Incentive Plan10.31*
    
    Note Modification Agreement dated March 18, 2004 between the Company and
Bank One, NA21.1*
    
    Subsidiaries of the Company23.1*
    
    Consent of Grant Thornton LLP
 57




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##### Table of Contents



Exhibit
    
    Description of Exhibit31.1*
    
    Certification of Chief Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.31.2*
    
    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.32.1*
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
   *
    
    Filed herewith.**
    
    Management contract or other compensatory plan or arrangement. C. The Registrant has not filed any reports on Form 8-K during the last
quarter of the period covered by this Report, except as follows: On November 17, 2003, we filed a Current Report on Form 8-K dated November
17, 2003, reporting events under Item 12. On November 24, 2003, we filed a Current Report on Form 8-K dated November
13, 2003, disclosing information under Item 5 and filing exhibits under Item 7. 58




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##### Table of Contents



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. TERAFORCE TECHNOLOGY CORPORATION
(Registrant) Date: March 30, 2004
    By:
    /s/ HERMAN M. FRIETSCHHerman M. FrietschChief Executive Officer Pursuant to the requirements of the Securities Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities indicated on March 30, 2004. /s/ HERMAN M. FRIETSCH
    
    /s/ ANTON VON AND ZU LIECHTENSTEINHerman M. Frietsch
Chief Executive Officer and Director
(Principal Executive Officer)
    
    Anton von and zu Liechtenstein, Director/s/ ROBERT P. CAPPS
    
    /s/ ROBERT E. GARRISON IIRobert P. Capps
Chief Financial Officer
(Principal Financial and Accounting Officer)
    
    Robert E. Garrison II, Director/s/ DAVID H. YEDWAB
      David H. Yedwab, Director
 59